Using Interest Rate Derivative Prices to Estimate LIBOR-OIS Spread Dynamics and Systemic Funding Liquidity Shock Probabilities

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

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