LIBOR Part I: LIBOR-OIS Spread




Hindsight
Let's jump back in time to 2007.  What indicator could we use to forecast an impending financial crisis?  One indicator to use is the 3-month LIBOR-OIS spread - the spread between a 3-month LIBOR (London Interbank Offered Rate) loan rate and an overnight OIS (overnight indexed swap) loan rate.

The OIS is taken on an equivalent period basis to the short-term loan (3-months in this case) as a series of overnight rates for that period added together.  The loan is an indexed swap, which tries to capture a consensus of what other parties are willing to trade (swap) for.

The spread helps to measure the money-market risk of lending long-term versus lending short-term on an unsecured basis.  The spread gives banks an idea of counter-party risk.

Because the LIBOR-OIS spread involves unsecured loans it represents risk associated with the debtor; where as secured loans involve the risk of the underlying loans in the security - not the counter-party issuing such securities.



Hindsight - it all seems so obvious now. It became much m
ore risky to lend 3-months than to lend overnight. Image taken from http://research.stlouisfed.org/publications/es/08/ES0825.pdf

Since the OIS is a type of overnight loan rate (referenced in the US to Fed Funds rate), let's look at what similar spreads looked like during the same time period as above:

3-Month LIBOR-Fed Funds spread.



3-Month LIBOR-Primary Credit spread. Primary credit is the discount window rate for "prime" borrowers.



Primary Credit-Fed Funds spread.





It all looks rather obvious now; things really hit the fan in 2008, and there were some visible signs of things to come back in 2007.  These spreads aren't useful for predicting future economic turmoil; in fact if you look at many of the above spreads over the past decades you will find similar changes (though not like what happened in 2008). 

The interest spreads instead offer a useful guide to understanding the relation between borrowing short and borrowing very-short.  The difference in interest rates can present opportunities for arbitrage - playing the difference in interest rates against one another.

Here is one last spread: 



Eurodollar-LIBOR spread (3-Month)

LIBOR-OIS remains a barometer of fears of bank insolvency. - Alan Greenspan