OIS Interest Rate and LIBOR-OIS Spread?

What is OIS Rate? 

OIS is an American Rate that is currently being pushed by NY Fed a lot in American markets after the recent global financial crisis. 

This is an interest rate that banks charge each other for an overnight lending to each other. Counterpart to this rate for interbank lending is called LIBOR, which I mentioned in my previous post. 

OIS rate when compared with corresponding LIBOR, is always lower. The rationale is a lending for just an overnight is much more safer than lending to a bank for a longer period say 3M or 1Yr. Since OIS matures overnight, there is a very little risk for counterparty default. This rate is heavily being used primarily in Derivatives instruments where collaterals are being posted by counterparties. 

What is LIBOR-OIS Spread? 

A spread is usually defined as a gap between two attributes such as Gap between two prices or Gap between two interest rates. 

A LIBOR-OIS spread is the gap between LIBOR rate and Overnight Indexed Swap rate. One can imagine that LIBOR will be more riskier than OIS due to longer tenors in LIBOR. The gap can be anywhere between 10-40 bps (1 basis point is 1% of 1%, 100 bp = 1%). In financial market, this gap is closely being monitored for 2 reasons: 

1. If Market sees that banks are still credible but gap is widening then it offers a great arbitrage opportunity for bankers. They can borrow in OIS and Lend in LIBOR.

2. If scenario 1 is not true then it simply means that Financial market is getting into trouble and banks dont feel comfortable in leading to each other for longer periods. 

During financial crisis of 2008, LIBOR - OIS spread jumped from 10-15 basis points to 350 basis points range. Hence, the spread between LIBOR-OIS can be seen as the price of banking risk. 

Hope this helps.

Nitin

LIBOR Interest Rate

What is LIBOR?

In this post I would like to discuss a very important interest rate from UK, LIBOR, that banks in UK use as a Benchmark.

LIBOR - London Interbank Offering Rate

LIBOR is the most important interest rate that is used in LONDON. It is the borrowing rate that banks charge each other for lending various currencies. The rate is published by BBA where the top 16 banks release their rates for charging to other banks and BBA publishes one rate after using some formula behind it.  LIBOR is then used as a benchmark and all financial instruments that require interest rate as a part, would use LIBOR as a benchmark and add some spread based on the credibility. 

In a simple way, consumers will need to pay an interest rate higher than the LIBOR because no one can borrow at LIBOR except the banks themselves. 

These borrowing and lending can happen in any currency such as USD, Euro, Pound and so on. Hence, there is a corresponding LIBOR for USD, EURO, Pound or other currencies. Other than currency, the next important attribute of the LIBOR is the tenor, the duration for which banks want to lend another bank or so. 

Hence, there would be a LIBOR USD rate for 1M, 3M, 6M, 1Y and similarly LIBOR Sterling rate for the same tenor points.

Usage: 

These rates are used as a benchmark to offer various financial instruments to consumers such as Mortgage Rate, Auto Loan Rate, Student Loan and so on and so forth.

Process is very Simple: 

Scenario 01 

Let's say Bank A's can borrow at Libor from Bank B 

Bank A has a customer C1 who wants a short term loan for 1 Yr

Bank A sees the customer C1 to be of less risky and happy to give loan at 0.5% Margin

Finally, Bank will charge Customer C1 an interest rate of Libor + 0.5% + Whatever Processing Fee 

Scenario 02 

Let's say Bank A's can borrow at Libor from Bank B 

Bank A has a customer C2 who wants a short term loan for 1 Yr

Bank A sees the customer C2 to be of more riskier than C1 BUT happy to give loan at 2% Margin

Finally, Bank will charge Customer C1 an interest rate of Libor + 2% + Whatever Processing Fee 

Same process can go for a borrowing in any other currency such as Euro, Sterling and so on. 

Hope this helps,

Nitin