Using Interest Rate Derivative Prices to Estimate LIBOR-OIS Spread Dynamics and Systemic Funding Liquidity Shock Probabilities
18 Pages Posted: 15 Feb 2010 Last revised: 3 May 2013
Date Written: May 2, 2013
Using interest rate derivative market prices, this paper derives the term structure of the LIBOR-overnight index swap (OIS) spread, which is considered as the funding liquidity risk premium, following the Cox–Ingersoll–Ross model. The probability density functions of the LIBOR-OIS spread constructed from its dynamics were fat-tailed distributions during the crisis of 2008 and the tails further extended after the Lehman failure reflecting deepened uncertainty about the funding liquidity risk. The dynamics provides information to estimate the probability of systemic funding liquidity shocks using a first-passage-time approach. The probability deviated from zero on 18 September 2008 to a material level that provided an early warning signal of the aggregate liquidity shock on 29 September 2008 when the interbank market was totally paralysed.
Keywords: Sub-Prime Crisis, Funding Liquidity Shocks, LIBOR-OIS Spread, First-Passage-Time Probability
JEL Classification: F31, G13
Suggested Citation: Suggested Citation