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