The Whys of the LOIS: Credit Skew and Funding Spread Volatility

Stéphane Crépey () and Raphael Douady ()
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Stéphane Crépey: LaMME - Laboratoire de Mathématiques et Modélisation d'Evry - INRA - Institut National de la Recherche Agronomique - UEVE - Université d'Évry-Val-d'Essonne - CNRS - Centre National de la Recherche Scientifique

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Abstract: The 2007 subprime crisis has induced a persistent disconnection between the Libor derivative markets of different tenors and the OIS market. Commonly proposed explanations for the corresponding spreads are a combination of credit risk and liquidity risk. However in the literature the meaning of liquidity is either not precisely stated, or it is simply defined as a residual spread after removal of a credit component. In this paper we propose a stylized equilibrium model in which a Libor-OIS spread (LOIS) emerges as a consequence of a credit component determined by the skew of the CDS curve of a representative Libor panelist (playing the role of the "borrower" in an interbank loan) and a liquidity component corresponding to a volatility of the spread between the refinancing (or funding) rate of a representative Libor panelist (playing the role of the "lender") and the overnight interbank rate. The credit component is thus in fact a credit skew component, whilst the relevant notion of liquidity appears as the optionality, valued by the aforementioned volatility, of dynamically adjusting through time the amount of a rolling overnight loan, as opposed to lending a fixed amount up to the tenor horizon on Libor. "At-the-money" when the funding rate of the lender and the overnight interbank rate match on average, this results, under diffusive features, in a square root term structure of the LOIS, with a square root coefficient given by the above-mentioned volatility. Empirical observations reveal a square root term structure of the LOIS consistent with this theoretical analysis, with, on the EUR market studied in this paper on the period half-2007 half-2012, LOIS explained in a balanced way by credit and liquidity until the beginning of 2009 and dominantly explained by liquidity since then.

Keywords: Libor; OIS; funding; credit; liquidity (search for similar items in EconPapers)
Date: 2014-12
Note: View the original document on HAL open archive server: https://hal.science/hal-01151315v1
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Published in 2014

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Related works:
Working Paper: The Whys of the LOIS: Credit Skew and Funding Spread Volatility (2014)
Working Paper: The Whys of the LOIS: Credit Skew and Funding Spread Volatility (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-01151315

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