euribor ois spread explained
TRANSCRIPT
How can the interbank spread be explained?
ECONOMIC RESEARCH
Author: Patrick Artus
We will analyse moves in the spread between the 3-m onth Euribor and the 3-
month OIS swap rate. This spread may be due to:
- intrinsic bank risk;
- liquidity risk;
- expected changes in the repo rate;
- general risk aversion .
We seek to draw a distinction between these various explanatory factors and,
based on these factors, to determine to what extent the recent widening in
the interbank spread will persist.
The only significant explanation established is tha t recent moves in the
interbank spread is linked to the RMBS spread, i.e. to a liquidity risk linked to
the losses on banks’ assets.
12 June 2008 - No. 250
Flash 2008 - 250 - 2
Flash
Euro 3-month interbank spread
We will consider the behaviour of the euro-zone 3-month interbank ra te (3-month Euribor) , over the period 2007-2008. Chart 1 shows the spreads between 3-month Euribor and, on the one hand, the 3-month OIS swap rate and, on the other hand, the ECB’s repo rate, with the noteworthy widening in the summer of 2007, and the spring of 2008. There are four possible explanations for the changes in the 3-month Euribor spread:
1. Increased intrinsic bank risk. The risk that banks as borrowers represent may be increased by the fall in value of the assets they hold, increased borrower default risk, and the fact that the reduced magnitude of securitisation increases the credit risks banks hold in their balance sheets. We represent the intrinsic risk of banks by the premium on banks’ CDs (Chart 2) , which shows a significant peak in March 2008.
2. Liquidity risk. When a bank lends to another bank, the liquidity risk is the risk that the lending bank may need funds before the loan matures (i.e. before the end of 3 months), because of its own liquidity requirements. These are linked to capital losses on the bank’s assets (on off-balance-sheet vehicles). We therefore represent the liquidity risk: - by an objective indicator of pressure due to the need for liquidity, i.e.
the spread between the overnight rate and the ECB’s repo rate of (Chart 3) , which has been very erratic, especially during the summer of 2007;
- by the spreads representing the prices of the banks’ assets : iTraxx spread (cross-over), and RMBS spread (Chart 4) , which increased until May 2008.
Chart 2 Euro zone: CDS spread, banks
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07 08
0
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100
150
200
250
300 * CDS Bank Senior 5Y
* CDS Bank Sub 5Y
Sources: Bloomberg, NATIXIS
Chart 2 Euro zone: Spread on banks’ CDS
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07 080
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100
150
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300 * CDS Bank Senior 5Y * CDS Bank Sub 5Y
Sources: Bloomberg, Natixis
Chart 1 Euro zone: Euribor, swaps and repo
rate spreads
0.0
0.2
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0.6
0.8
1.0
07 08
0.0
0.2
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0.8
1.0 Spread of 3-month Euribor – 3-month OIS swaps
Spread of 3-month Euribor – euro Repo
Sources: Datastream, NATIXIS
Chart 1Euro zone: Euribor, swaps and repo yield
spreads
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07 08
0.0
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3-month Euribor/3-month OIS swaps yield spread 3-month Euribor/euro repo yield spread
Sources: Datastream, Nat ixis
Flash 2008 - 250 - 3
Flash
3. Expected changes in repo rates If markets expect a hike in the ECB’s repo rates (for example) before the end of 3 months, it is normal for the Euribor/repo spread to widen; the Euribor/OIS spread may change if the speed at which the two types of interest rates react to a change in the ECB’s key intervention rate differs. We illustrate the markets’ expectations by the spread between the Euribor rate for the December 2008 contract and the spot rate (Chart 5) .
The market expected a rate cut between the summer of 2007 and the spring of 2008, but since May 2008 it has expected a rate hike .
4. Risk aversion
A rise in general risk aversion increases all risk premia, including the ones we are looking at in this Flash. We also represent risk aversion (as with the risk of capital loss) by the iTraxx spread . We therefore arrive at the econometric model: Euribor/OIS spread = f (banks CDs, overnight/repo spread, iTraxx spread, RMBS spread, Euribor Dec. 2008/3-month Euribor spread).
Chart 3 Euro zone: spread on day-to-day – euro repo rates
-0.6
-0.4
-0.2
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0.6
07 08
-0.6
-0.4
-0.2
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0.6
Sources: Datastream, Natixis
Chart 3Euro zone: Overnight rate/euro repo yield
spread
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-0.4
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0.6
07 08
-0.6
-0.4
-0.2
0.0
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0.6
Sources: Datastream, Nat ixis
Chart 4 iTraxx indices and spread RMBS AAA
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Jan. 07 May 07 Sept. 07 Jan. 08 May 08 Sept. 08
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iTraxx X-Over 5 years (on-the-run)
Asset-Backed Securities, Home Equity Loans, Fixed Rate (AAA)
Sources: Bloomberg, Natixis
Chart 4 Itraxx indices and RMBS AAA spread
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Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08
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iTraxx X-Over 5 years (on-the-run) Asset-Backed Securities, Home Equity Loans, Fixed Rate (AAA)
Sources: Bloomberg, Natixis
Chart 5 Euro zone: spread Euribor maturity Dec. 2008 -
3-month spot Euribor
-1.25
-1.00
-0.75
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07 08
-1.25
-1.00
-0.75
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0.75
Sources: Datastream, Natixis
Chart 5Euro zone: Euribor maturity Dec. 2008/3-month
Euribor spot yield spread
-1.25
-1.00
-0.75
-0.50
-0.25
0.00
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07 08
-1.25
-1.00
-0.75
-0.50
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0.75
Sources: Datastream, Natixis
Flash 2008 - 250 - 4
Flash
Empirical results These are clear: very definitely, the best explanation is obtained w ith the RMBS spread (AAA) : 3-month Euribor rate - 3-month OIS swap rate = -3.8+0.15 RMBS spread (2.8) (36.3) R²=0.80 3-month Euribor rate - EUR repo rate = 20.2 + 0.10 RMBS spread (13.7) (23.7) R²=0.60 The other variables add nothing to the explanation. Chart 6 shows the econometric adjustment obtained.
Chart 6Econometric adjustment: 3-month Euribor rate/3-
month OIS swap rate yield spread (as %)
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07 08
-0.4
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Observed (LH scale)
Adjusted (LH scale)
Residual (RH scale)
Sources: Datastream, Natixis
Conclusion: Is the interbank spread
temporary or durable?
One may believe that the 3-month interbank spread (Euribor - OIS) is: - durable if it depends on the intrinsic rise in bank risk , where the various
factors (decline in securitisation, etc.) lead to a lasting rise in this risk; - temporary if it depends on other factors (liquidity risk), risk aversion,
expected hike in the ECB’s key rates, which are themselves temporary. We have seen that first and foremost, the RMBS spread, representing the value
of banks’ assets, appears to be the principal expla natory variable of the 3-month Euribor spreads . The pressure on the OIS/Euribor spreads therefore m ostly seems to be accounted for by the liquidity risk only , which is in fact good news, because this risk, unlike default risk, is of a more temporary nature.