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Economic SYNOPSES

short essays and reports on the economic issues of the day
2009 I Number 24

What the Libor-OIS Spread Says
Daniel L. Thornton, Vice President and Economic Adviser he term London interbank offer rate (Libor) is the ity constrained, borrowing banks would have to pay a highrate at which banks indicate they are willing to lend er rate when they borrow from each other than when they to other banks for a specified term of the loan. The borrow in the CD market, where lenders are not “liquidity term overnight indexed swap (OIS) rate is the rate on a constrained.” derivative contract on the overnight rate. (In the United States, the overnight rate is the effective federal funds rate.) “Libor-OIS remains a barometer In such a contract, two parties agree that one will pay the of fears of bank insolvency.” other a rate of interest that is the difference between the term OIS rate and the geometric average the overnight —Alan Greenspan federal funds rate over the term of the contract. The term OIS rate is a measure of the market’s expectation of the Risks premiums generally tend to increase in an environovernight funds rate over the term of the contract. There ment of increased uncertainty, such as periods of financial is very little default risk in the OIS market because there is no exchange of principal; funds are exchanged only at turmoil and recession. In the case of recession, the risk the maturity of the contract, when one party pays the net premium increases because the rate on the default-risk-free asset falls relative to the rate for the risky asset as interest interest obligation to the other. rates decline—there is a flight to safety. The term Libor-OIS spread is assumed to be a measure Figure 1 shows the daily term Libor-OIS spreads for of the health of banks because it reflects what banks believe terms of 1, 3, and 6 months: There was a sharp rise in the is the risk of default associated with lending to other banks. term spreads on August 9, 2007, after a lengthy period of Indeed, former Fed Chairman Alan Greenspan stated recently that the “Libor-OIS remains a barometer of fears of Figure 1 bank insolvency.” He then noted 4.00000 that “that fear has been substantially reduced since mid-October, 1-Month Libor-OIS 3.50000 3-Month Libor-OIS but the decline has stalled well 6-Month Libor-OIS short of any semblance of normal 3.00000 markets,” suggesting that the still-high Libor-OIS spreads were 2.50000 an indication of problems in the banking industry. There is no 2.00000 doubt that changes in the LiborOIS spread reflect changes in 1.50000 risk premiums rather than changes in liquidity premiums— 1.00000 premiums that reflect banks’ 0.50000 desire for liquidity: The difference between the rate on term 0.00000 certificates of deposit (CD) and the equivalent-term Libor rate is very small. If banks were liquid-

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0 bankruptcy.5 basis points—for a period after the Lehman announcement. 2008. following 1. the Libor-OIS spread has averaged about 40 to 50 basis Figure 2 shows the 6-month Libor-OIS spread and the points more suggests that the risks might now be somewhat spread between the rate on 6-month AAA-rate corporate higher in banking than the economy more generally. The spread between so in the banking industry despite considerable efforts of lower-rated corporate bonds and equivalent-maturity the government and the Fed to aid that industry. The spreads increased to very high levels—about 350 0. this interpretation suggests that risks have risen more bonds and the 6-month T-bill rate.and 6-month Libor-OIS spreads remain much higher before the Lehman announcement. the 1-month Libor-OIS spread on April 6.0 subsequently narrowed. there was little difference in the spreads across terms of the 3. both risk premiums rose dramatically on news of Lehman’s bankruptcy. however. it is worth noting that there was considerable risk premium in the economy generally.Economic SYNOPSES Federal Reserve Bank of St.5 assets. The fact that of increased risk endemic to the economy more generally. I try. The 6-month corporate-Treasury spread reflects the Finally. Indeed. This sharp rise in the term 6-Month AAA Corp-Treas Spread 6-Month Libor-OIS Spread spreads is associated with market 3.stlouisfed. However.5 the announcement that Lehman Brothers had filed for Chapter 11 1. but have 0. which likely reflects than they were It appears that the spreads reflect the market’s perception the concerns associated with the recession. Both spreads remain elevated 3. Figure 2 Indeed. However. Moreover. the spread is much wider. Indeed. news to the Libor-OIS spread before August 2007. Louis 2 being small and relatively constant. Hence. Both risk premiums variation in the 6-month corporate-Treasury spread relative increased dramatically in early August 2007. Treasuries behaves similarly. was about 28 basis points. 2009 Views expressed do not necessarily reflect official positions of the Federal Reserve System.org . only about 15 basis points the Libor-OIS spread increased somewhat more than the higher than it was before early August 2007.5 spreading to the broader mortgage market. the corporate-Treasury spread. 2009.0 ated around a much higher level until September 17. Perhaps not surprisingly 3/ 2/ 06 3 3/ /06 3 4/ /06 3 5/ /06 3/ 6/ 06 3 7/ /06 3/ 8/ 06 3 9/ /06 10 3/06 / 11 3/0 /3 6 12 /06 /3 1/ /06 3 2/ /07 3 3/ /07 3/ 4/ 07 3 5/ /07 3/ 6/ 07 3 7/ /07 3 8/ /07 3 9/ /07 10 3/0 / 7 11 3/07 /3 12 /07 /3 1/ /07 3 2/ /08 3 3/ /08 3 4/ /08 3 5/ /08 3 6/ /08 3 7/ /08 3 8/ /08 3 9/ /08 3 10 /08 /3 11 /08 / 12 3/0 /3 8 1/ /08 3 2/ /09 3 3/ /09 3 4/ /09 3/ 09 1/ Posted on May 11.0 concerns that problems in the subprime mortgage market were 2. research. These term spreads fluctu2. the that the subprime problems were spreading beyond the Libor-OIS spread was very small and nearly constant. This behavior is consistent with the idea that financial markets subprime market appears to have affected risk premiums were not adequately gauging the risk associated with mortin the economy generally and not simply the banking indusgage lending during the period. relative to their pre-August 2007 levels.