LIBOR-OIS spread

The Libor-OIS spread is an important barometer of stress in the banking system. The term London interbank offer rate (LIBOR) is the rate at which banks indicate they are willing to loan to other banks for a specified term of the loan. The term overnight indexed swap (OIS) rate is the rate on a derivative contract on the overnight rate (In the U.S. the overnight rate is the effective federal funds rate.) In such a contract, two parties agree that one will pay the other party a rate of interest that is the difference between the term OIS rate and the geometric average of the federal fund's rate over the term of the contract. Thus, the term OIS rate is the market's expectation of the federal fund's rate over the term of the contract. There is very little risk in the OIS market because there is no exchange of principal; funds are only exchanged at the end of the contract, when one party pays net interest obligation to the other party. The term Libor-OIS spread is be a measure of the health of the banks because it measures what banks believe is the risk of default associated with lending to other banks. Changes in Libor-OIS spread reflect changes in risk premiums and liquidity premiums.