An overnight indexed swap
) is an interest rate swap
where the periodic floating payment is generally based on a return calculated from a daily compound interest
investment. The reference for a daily compounded rate is an overnight rate (or overnight index rate) and the exact averaging formula depends on the type of such rate.
The index rate is typically the rate for overnight unsecured lending between banks, for example the Federal funds rate
for US dollars, Eonia for Euros or Sonia for sterling. The fixed rate of OIS is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR) because there is limited counterparty risk.
The LIBOR–OIS spread
is the difference between LIBOR and the (OIS) rates. The spread between the two rates is considered to be a measure of health of the banking system. It is an important measure of risk and liquidity in the money market, considered by many, including former US Federal Reserve
chairman Alan Greenspan, to be a strong indicator for the relative stress in the money markets. A higher spread (high Libor) is typically interpreted as indication of a decreased willingness to lend by major banks, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes.
The LIBOR–OIS spread has historically hovered around 10 basis points (bps). However, in the midst of the financial crisis
of 2007–2010, the spread spiked to an all-time high of 364 basis points in October 2008, indicating a severe credit crunch. Since that time the spread has declined erratically but substantially, dropping below 100 basis points in mid-January 2009 and returning to 10–15 basis points by September 2009.