LIBOR-OIS

http://research.stlouisfed.org/publications/es/09/ES0924.pdf


The term London interbank offer rate (Libor) is the
rate at which banks indicate they are willing to lend
to other banks for a specified term of the loan. The
term overnight indexed swap (OIS) rate is the rate on a
derivative contract on the overnight rate. (In the United
States, the overnight rate is the effective federal funds rate.)
In such a contract, two parties agree that one will pay the
other a rate of interest that is the difference between the
term OIS rate and the geometric average the overnight
federal funds rate over the term of the contract. The term
OIS rate is a measure of the market’s expectation of the
overnight funds rate over the term of the contract. There
is very little default risk in the OIS market because there
is no exchange of principal; funds are exchanged only at
the maturity of the contract, when one party pays the net
interest obligation to the other.
The term Libor-OIS spread is assumed to be a measure
of the health of banks because it reflects what banks believe
is the risk of default associated with lending to other banks.
Indeed, former Fed Chairman Alan Greenspan stated
recently that the “Libor-OIS
remains a barometer of fears of
bank insolvency.”

Metrics To Track Funding Stress

Some metrics to be wary of in light of European Sovereign Stress...

Swap Spreads

• A sharp widening in two-year swap spreads reflects an increase in expected Libor rates versus short-term government borrowing and is a measure of increased funding stress / deteriorating credit conditions in inter-bank borrowing.
• A sharp widening in five-year swap spreads reflects a flight-to-quality trade when investors seek safer government debt over a proxy for highly rated, non-financial corporate borrowers.
• The EUR Basis swap represents the give-up in the market rate in Euribor versus Libor and represents the scarcity of dollar funding for borrowers in the euro zone.  A very large negative spread represents a larger premium for Libor funding over Euribor funding.
• (Swap spreads are a popular way to indicate the credit spreads in a market.  It is defined as the spread paid by the fixed-rate payer of an interest rate swap over the on the run treasury with the same maturity as the swap.  For example, if the fixed-rate of a 5-year fixed-for-float LIBOR swap is 7.26% and the 5-year Treasury is yielding at 6.43%, the swap spread is 7.26% - 6.43% = 83 bps.)

Eurodollar Futures

• A sharp increase in yields in the first four contracts and a simultaneous rally in the next four represents signs of funding stress, as short-term borrowing rates spike relative to the rest of the funding curve.
• ( Eurodollar futures contract refers to the financial futures contract based upon Eurodollar deposits (which are US dollar-denominated deposits), traded at the CME.  They are a way for companies and banks to lock in an interest rate today, for money it intends to borrow or lend in the future.  Each CME Eurodollar futures contract has a notional of "face value" of $1,000,000.
  
  CME Eurodollar futures prices are determined by the market's forecast of the 3-month USD LIBOR interest rate expected to prevail on the settlement date.
  
  A single Eurodollar future is similar to a forward rate agreement to borrow or lend US$1,000,000 for three months starting on the contract settlement date.  Buying the contract is equivalent to lending money and selling the contract short is equivalent to borrowing money.  (Note that a contract is different from an actual loan due to a lack of convexity as well as the fact that credit risk is only on the margin account balance.) )

Liquid Forward Spreads

• The 3s1s basis is a spread to one-month Libor that investors can lock in in exchange for three-month Libor at a specified forward date.  Widening occurs as long-term funding becomes more scarce, reflecting higher liquidity and term premium
• Similarly a widening in the 3s6s basis reflects scarce long-term funding in the money market and reflects higher liquidity and term premium.
• The FRA-OIS spread represents the spread between the uncollateralized Libor borrowing rate in the inter-ban market versus a highly correlated proxy for the expected funds rate over a three-month period at a specified forward date.  A widening in spread represents increased funding stress in teh banking system.

Credit Default Swaps

• A widening in CDS across major indices represents a deterioration in the credit outlook

EU Debt Spread

• Represents the spread of five-year European sovereign debt to the five-year German benchmark.  A sharp widening in these spreads represents a deterioration of the fiscal outlook for these sovereigns.

FX

• A strengthening of the dollar versus euro represents scarcity of overseas dollars potentially driven by funding stress.

3M LIBOR

• Represents the three-month rate that banks are willing to lend in the inter-bank market.  A sharp increase in rates is reflective of more demand versus supply of loanable funds in the inter-bank market.

French Banks Equity and CDS

• A decline in the French bank stocks and/or a widening of their CDS may reflect an increase in the likelihood of a sovereign default by Greece given the large exposure of French banks to Greek sovereign debt.

Overnight Indexed Swap (OIS)

An Overnight Indexed Swap (OIS) (an interest-rate derivative) is a fixed/floating interest rate swap with the floating leg computed using a published overnight rate index, typically considered less risky than the corresponding interbank rate (LIBOR), in the case of the USD, the Fed Funds Effective Rate.

Two parties agree to exchange at maturity the difference between interest accrued at the fixed rate & interest accrued at the compounded floating rate on the agreed notional amount of the swap.

Net payment is made two business days after maturities

The basis convention is Annual ACT/360 (or Actual/360)

(Interest = Principal x CouponRate x Factor)

(Factor = (Actual days between the start and end dates inclusive)/360) (i.e. Assumes 360 day year)

swap receiver... receives fixed rate payments (and makes floating rate payments)

swap payer... receives floating rate payments (and makes fixed rate payments)

An OIS acts as a perfect hedge for a cash instrument...

Cash can be lent daily (i.e. in a daily accruing interest bearing account) for daily interest receipts. In contrast, the swap receiver effectively makes daily interest payments. If the daily rates 'line up,' the cash inflow can be matched with the cash outflow, the the OIS receiver has hedged the daily rate change uncertainty with a fixed rate.

OIS rates (or, in particular, the difference or 'spread' between OIS rates & LIBOR) are an important measure of risk & liquidity in the money market, considered by many to be a strong indicator for the relative stress in money markets. A higher spread is typically interpreted as an indication of decreased willingness to lend by major banks, while lower spread indicates higher liquidity in the market. The spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions & general availability of funds for lending purposes