The Definition of a LIBOR Spread

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LIBOR's significance owes much to London's centrality in world finance.
LIBOR's significance owes much to London's centrality in world finance. (Image: london bridge image by Adkok from <a href='http://www.fotolia.com'>Fotolia.com</a>)

A LIBOR spread is any divergence between the London Interbank Offered Rate, called LIBOR, and another rate. The LIBOR often is compared with the overnight indexed swap rate, or OIS.

LIBOR's Significance

LIBOR is the rate that banks charge one another for overnight loans, as calculated on a daily basis by the British Bankers' Association. It is followed worldwide.

LIBOR tracks overnight loan rates between banks.
LIBOR tracks overnight loan rates between banks. (Image: Night image by Yri Hramov from <a href='http://www.fotolia.com'>Fotolia.com</a>)

Significance of the OIS

An overnight indexed swap is a specialized form of interest-rate swap, in which the floating side of the transaction is equal to the average of an overnight index on each day of the payment period.

The LIBOR-OIS Spread

Because of its averaging feature, and because OIS contracts do not involve initial cash flows (which reduces default risk), the OIS rate is less volatile than the LIBOR rate.

History

In the early summer of 2007, the LIBOR/OIS spread was just 10 basis points, or bps. In August, as a credit crunch got under way, the spread rose quickly. It reached 85 bps on Sept. 14, 2007, when the Bank of England announced the rescue of Northern Rock, a major mortgage lender in the United Kingdom.

2008 and 2009

By the summer of 2008, the LIBOR/OIS spread had settled into what seemed a new normal at around 100 bps. When Lehman Bros. filed for bankruptcy in September 2008, setting off a global bankruptcy crisis, the spread spiked, reaching 365 bps on Oct. 10 of that year.

By the second half of 2009, when there was a general sense that the worst of the crisis was over, the spread returned to its pre-Northern-Rock level.

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