Overnight indexed swap

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An overnight indexed swap (OIS) is an interest rate swap where the periodic floating payment is generally based on a return calculated from a daily compound interest investment. The reference for a daily compounded rate is an overnight rate (or overnight index rate) and the exact averaging formula depends on the type of such rate.

The index rate is typically the rate for overnight unsecured lending between banks, for example the Federal funds rate for US dollars, Eonia for Euros or Sonia for sterling. The fixed rate of OIS is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR) because there is limited counterparty risk.[1][2]

The LIBOR–OIS spread is the difference between LIBOR and the (OIS) rates. The spread between the two rates is considered to be a measure of health of the banking system.[3] It is an important measure of risk and liquidity in the money market,[4] considered by many, including former US Federal Reserve chairman Alan Greenspan, to be a strong indicator for the relative stress in the money markets.[5] A higher spread (high Libor) is typically interpreted as indication of a decreased willingness to lend by major banks, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes.[6]

The LIBOR–OIS spread has historically hovered around 10 basis points (bps). However, in the midst of the financial crisis of 2007–2010, the spread spiked to an all-time high of 364 basis points in October 2008, indicating a severe credit crunch. Since that time the spread has declined erratically but substantially, dropping below 100 basis points in mid-January 2009 and returning to 10–15 basis points by September 2009.[7]

Risk barometer[edit]

Three-month LIBOR is generally a floating rate of financing, which fluctuates depending on how risky a lending bank feels about a borrowing bank. The OIS is a swap derived from the overnight rate, which is generally fixed by the local central bank. The OIS allows LIBOR-based banks to borrow at a fixed rate of interest over the same period. In the United States, the spread is based on the LIBOR Eurodollar rate and the Federal Reserve's Fed Funds rate.[3]

LIBOR is risky in the sense that the lending bank loans cash to the borrowing bank, and the OIS is stable in the sense that both counterparties only swap the floating rate of interest for the fixed rate of interest. The spread between the two is, therefore, a measure of how likely borrowing banks will default. This reflects counterparty credit risk premiums in contrast to liquidity risk premiums.[3] However, given the mismatch in the tenor of the funding, it also reflects worries about liquidity risk as well.

Historical levels[edit]

In the United States, the LIBOR–OIS spread generally maintains around 10 bps. This changed abruptly, as the spread jumped to a rate of around 50 bps in early August 2007 as the financial markets began to price in a higher risk environment. Within months, the Bank of England was forced to rescue Northern Rock from failure. The spread continued to maintain historically high levels as the crisis continued to unfold.[3]

As markets improved, the spread fell and as of October 2009, stood at 10 bps once again, only to rise again as struggles of the PIIGS countries threatened European banks. As of December 2011, the spread again stands at 40+ bps level.

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