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

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Tsz-Kin Chung

IHS Markit; Tokyo Metropolitan University

Chi-Fai Lo

The Chinese University of Hong Kong

Date Written: May 2, 2013

Abstract

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

Hui, Cho-Hoi and Chung, Tsz-Kin and Lo, Chi-Fai, Using Interest Rate Derivative Prices to Estimate LIBOR-OIS Spread Dynamics and Systemic Funding Liquidity Shock Probabilities (May 2, 2013). Asia-Pacific Financial Markets, Vol 20(2): 131–146, (2013). Available at SSRN: https://ssrn.com/abstract=1551147

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Tsz-Kin Chung (Contact Author)

IHS Markit ( email )

Tokyo
Japan

Tokyo Metropolitan University

1-1 Minami Ohsawa Hachioji-shi
Tokyo 192-0397
Japan

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

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