Question

Compare LIBOR and OIS as benchmark rates that could be used in valuing interest rate swaps.

Answer 1

DIFFERENCE BETWEEN LIBOR VS OIS

LIBOR

LIBOR(officially known as ICE LIBOR since February 2014) is the average interest rate that banks charge each other for short-term, unsecured loans.2 1 The rate for different lending durations—from overnight to one-year—are published daily. The interest charges on many mortgages, student loans, credit cards, and other financial products are tied to one of these LIBOR rates.

LIBOR is designed to provide banks around the world with an accurate picture of how much it costs to borrow short term. Each day, several of the world’s leading banks report what it would cost them to borrow from other lenders on the London interbank market. LIBOR is the average of these responses.

OIS

The OIS, meanwhile, represents a given country’s central bank rate throughout a certain period; in the US, that's the Fed funds rate—the key interest rate controlled by the Federal Reserve, commonly called "the Fed". If a commercial bank or a corporation wants to convert from variable interest to fixed interest payments—or vice versa—it could “swap” interest obligations with a counterparty. For example, a US entity may decide to exchange a floating rate, the Fed Funds Effective Rate, for a fixed one, the OIS rate. In the last 10 years, there's been a marked shift toward OIS for certain derivative transactions.3

Because the parties in a basic interest rate swap don’t exchange principal, but rather the difference of the two interest streams, credit risk isn’t a major factor in determining the OIS rate. During normal economic times, it’s not a major influence on LIBOR, either. But we now know that this dynamic changes during times of turmoil, when different lenders begin to worry about each other’s solvency.

The Spread

Before the subprime mortgage crisis in 2007 and 2008, the spread between the two rates was as little as 0.01 percentage points. At the height of the crisis, the gap jumped as high as 3.65%.1

The following chart shows the LIBOR-OIS spread before and during the financial collapse. The gap widened for all LIBOR rates during the crisis, but even more so for longer-term rates.

(Source: Federal Reserve Bank of St. Louis)

CONCLUSION

The LIBOR-OIS spread represents the difference between an interest rate with some credit risk built-in and one that is virtually free of such hazards. Therefore, when the gap widens, it’s a good sign that the financial sector is on edge.