Understanding the LIBOR-OIS Spread

10/02/2008 11:26 am EST

Focus: FOREX

S. Wade Hansen

Co-Founder, Profiting with Forex (PFX) and Learning Markets

Why Do Analysts Watch the LIBOR-OIS Spread?

Market analysts are always looking for indicators that can give them a glimpse into what is happening in the market so they can get an idea of what is going to happen in the future. The LIBOR-OIS spread gives analysts just such a glimpse into the health of the global credit markets.

LIBOR-OIS Spread

The LIBOR-OIS spread is a comparison between the London Interbank Offered Rate (LIBOR) and the overnight index swap (OIS) rate. You see, analysts aren't too concerned with the nominal value of each of these rates. What they are concerned with is the relationship between these two rates. Typically, LIBOR is higher than the overnight index swap rate, but knowing that alone isn't enough. You need to know what the spread is.

To calculate the LIBOR-OIS spread, you simply subtract the overnight index swap rate from the three-month LIBOR rate. For instance if the three-month LIBOR rate is at 3.25 percent and the overnight index swap rate is at 2.50 percent, the LIBOR-OIS spread is 0.75 percent, or 75 basis points (3.25 - 2.50 = 0.75).

What Does the LIBOR-OIS Spread Tell Us?

When the LIBOR-OIS Spread is increasing, it tells us that banks believe the other banks they are lending to have a higher risk of defaulting on the loans so they are charging a higher interest rate to offset this risk. It also tells us that the credit markets are not functioning as smoothly as they could be—which is sign of potential economic contraction.

When the LIBOR-OIS Spread is decreasing, it tells us that banks believe the other banks they are lending to have a lower risk of defaulting on the loans so they are charging a lower interest rate to offset this risk. It also tells us that the credit markets are functioning smoothly—which is sign of potential economic expansion.

By S. Wade Hansen of PFXGlobal.com and LearningMarkets.com

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