I’ve been watching this index for awhile as a proxy for risk within several banking systems. Mostly because I know that’s how people view it. But to be honest, I’m having a hard time breaking down the OIS and Libor into components (ie. presence of various forms of credit / term risk / interest rate risk, inflation etc) and coming up with an exact understanding of what the spread represents. Anyone have a high level of familiarity and care to share?
its a measure of liquidity more than anything else. libor is the base for cp, mtn, and swaps that help the banks make investments and extend credit so the spread shows the current demand for money from banks.
the biggest issue right now is the “LIE” in Libor
OIS-curve is the last real derivative curve; good proxy for risk-free interest rate. Libor should be the offer-side for cash, but it no longer means anything. So I would construct a term-structure with cash rates (real cash for short maturities and swaps vs 3m libor+cross currency basis swap spread for longer maturities) minus OIS. With OIS virtually risk-free the spread would now be a pool of liquidity & credit risk. Not too much inflation and term risk, which you would observe otherwise. Break-evens of mid-term inflation swaps for instance. Teem risk is quite tough to proxy…
OK, that makes sense IRS-Trader, however, since OIS is federal funds, how does it not reflect the same issuer credit risk as libor since both are interbank?
Does it have to do with Libor being unsecured and OIS being secured?
Fed funds typically are unsecured. OIS is just a swap, so it does not reflect credit risk on the underlying, you may be right there.
http://www.analystforum.com/phorums/read.php?1,842789,842789#msg-842789 OIS spreads explained - to those interested Posted by: rohufish (IP Logged) Date: October 7, 2008 01:02PM so, i dug into this mysterious OIS spread term, which we did not cover in the CFA program by the way - they need to add it to the curriculum. for those who are curious, i’m taking a crack at writing this down. it helps me clear out my thinking also. OIS spread is essentially a way to measure the pure credit risk premium for interbank lending. i used to think the TED spread did that, but remember, the TED spread is LIBOR yield minus T-bill yield for a given maturity. i.e. borrower is a private bank for LIBOR, but govt for T-bill. i.e. spread compares apples to oranges since borrowers are different. now, the fedfunds are usually secured lending between banks, with treasuries used as collateral, and the LIBOR is for unsecured loans between banks. so that would be apples to apples (same borrower - a private sector bank). ordinarily, you’d like to compare fedfunds to LIBOR, but there is no ‘3-mth or 1-mth’ fedfunds (it is an overnight transaction) likewise, there is no ‘overnight LIBOR’. thus the need to measure the spread to an identical maturity. thats where the OIS swap rate comes into the picture. it is the fixed rate exchanged for a floating overnight fedfunds effective rate (note that effective rate is the actual market rate, not the target rate) for the given maturity. thus, we have same maturity, same borrower, but different credit risk (secured vs unsecured). giving pure interbank lending credit spread (for A rated banks of course). in summary, 3-month OIS spread = 3-month LIBOR - fixed rate for 3-month OIS swap --------------------- also… http://www.analystforum.com/phorums/read.php?1,832288,832613#msg-832613
Thanks Darian, appreciate all the help guys. This OIS business was making me feel stupid.
Good explanation above. Just note that Libor rates don’t reflect reality. Just compare Libor to Cash (where real turnover is happening). Libor today is only vehicle for indexing loans, derivatives,… If you want to assess risk types adequately you need cash rates. Using OIS is fine like posted above…at least thats the way i got in my launchpad;)