On the White Board - January 2009

Jan 15, 2009

Measuring the Risk of Money Market Distress

Since August 2007 the 3 month Libor-OIS spread has become one of the most watched indicators for distress in the money markets. The Libor rate is the rate of borrowing /lending unsecured funds in the interbank market. The overnight index swap (OIS ) rate is a fixed rate paid at maturity (1 week to up to 2 years) in exchange for interest accrued through daily compounding of an overnight reference rate (Fed Fund Rate, Eonia, Sonia,..). An OIS is a tool used by banks to control and hedge exposure to short term funding, the swap rate being often viewed as an expectation of future policy rates. For hedge funds the spread offers speculative possibilities in the interbank money market.

The spread widened spectacularly in the summer 2007 as a consequence of banks being unwilling to lend beyond daily horizons or charging higher (Libor) rates. The origin for the spread is usually described as a sum of insurance to protect against future policy rates, plus credit and liquidity (shortage of capital) premia paid on interbank deposits. Indeed, unlike deposit rates, overnight indexed swaps require no principal exchange and use the traditional credit risk mitigation techniques (netting, collateral).

In terms of risk management, a non-constant spread indicates interest rate basis risk and implies that two distinct risk factors should be considered. Since the Libor-OIS spread changed from a fairly constant 5 to 10 bps regime to a much more volatile times series, we have added OIS time series to our interbank data. We are also increasing our coverage in terms of futures contracts based on OIS rates: Federal Fund Futures (based on arithmetic averaging of the overnight index), overnight index futures (based on daily compounding of the overnight index) and swap index futures (based on the x-month OIS rate at futures expiry date).