Until a few years ago, most traders didn’t pay much attention to the difference between two important interest rates, the London Interbank Offered Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate. That’s because, until 2008, the gap, or “spread,” between the two was minimal.

But when LIBOR briefly skyrocketed in relation to OIS during the financial crisis beginning in 2007, the financial sector took note. Today, the LIBOR-OIS spread is considered a key measure of credit risk within the banking sector. (For a glimpse into the possible evolution of these two rates, read "Will OIS Replace LIBOR?")

To appreciate why the variation in these two rates matters, it’s important to understand how they differ. LIBOR is the average interest rate that banks charge each other for short-term, unsecured loans. 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.

OIS, meanwhile, represents the assumed Fed Funds rate – the key interest rate controlled by the Federal Reserve – over the course of certain period. If a commercial bank or a corporation wants to convert from variable to fixed interest payments – or vice versa – it could “swap” interest obligations with a counterparty. For example, a U.S. entity may decide to exchange a floating rate, the Fed Funds Effective Rate, for a fixed one (OIS).

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 ties, 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.

Prior to the financial collapse 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%.

Figure 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.

libor chart

(Source: Federal Reserve Bank of St. Louis)

The Bottom Line

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.

Related Articles
  1. Economics

    What Is The Relationship Between The Federal Funds, Prime And LIBOR Rates?

    The prime rate and LIBOR rate, two of the most prominent benchmark rates, tend to track the federal funds rate closely over time. However, during periods of economic turmoil, LIBOR appears more ...
  2. Economics

    What Is ICE LIBOR And What Is It Used For?

    In the case of ICE LIBOR, an innocent-sounding set of letters has a profound bearing on every loan you make.
  3. Investing News

    The LIBOR Scandal

    Barclays and other banks are alleged to have submitted artificially low LIBOR rates between 2007 and 2009.
  4. Options & Futures

    An Introduction To LIBOR

    This influential rate is published daily in Britain, and felt all around the world.
  5. Investing News

    Timing of the Fed Interest Rates Hike

    Until the beginning of August, Fed watchers expected the central bank to raise rates in September. However, recent news pertaining to China’s slowing economy and its devaluation of the yuan have ...
  6. Markets

    How to Use Blockchain to Buy and Sell Gold

    Most people still haven't heard of the term "blockchain," but chances are you will soon. A blockchain is a tamper-proof, distributed electronic ledger that exists across a decentralized network. ...
  7. Term

    What is the Macro Environment?

    The macro environment is the conditions existing in an economy as a whole, rather than in a single sector or region.
  8. Economics

    Puerto Rico Will Soon Become America's Greece

    Explore the similarities that exist between Puerto Rico in relation to the United States and Greece in relation to the European Union.
  9. Taxes

    What's Wrong with the American Tax System

    American's are highly taxed and we still run a deficit. We explain why.
  10. Mutual Funds & ETFs

    The 8 Best ETFs for Rising Rates, Flagging Stocks

    With the markets starting to sag, should you go on the defensive? If so, which ETFs should you consider?
RELATED TERMS
  1. LIBOR Scandal

    A scandal in which financial institutions were accused of fixing ...
  2. LIBOR-in-Arrears Swap

    A swap in which the interest paid on a particular date is determined ...
  3. Monetary Policy

    The actions of a central bank, currency board or other regulatory ...
  4. Go-To Rate

    The interest rate that will come into effect after an introductory ...
  5. Purchase Rate

    The interest rate applied to purchases made with a credit card.
  6. Negative Interest Rate Policy (NIRP)

    A negative interest rate policy (NIRP) is an unconventional monetary ...
RELATED FAQS
  1. How is Libor determined?

    Libor is the major rate used to price debt stock. Libor is actually a set of several benchmarks that reflect the average ... Read Full Answer >>
  2. What is the difference between LIBOR, LIBID and LIMEAN?

    LIBOR, LIBID and LIMEAN are all reference rates used to benchmark short-term interest rates. The London Interbank Offered ... Read Full Answer >>
  3. What is the difference between LIBID and LIBOR?

    Both LIBID and LIBOR are rates primarily used by banks in the London interbank market. The London interbank market is a ... Read Full Answer >>
  4. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  5. How can the federal reserve increase aggregate demand?

    The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates. Aggregate demand is a measure ... Read Full Answer >>
  6. How does the stock market react to changes in the Federal Funds Rate?

    The stock market reacts to changes in the federal funds rate in various ways depending on where it is in the business cycle. ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!