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

Following the bankruptcy of Lehman Brothers in mid-September 2008, there were severe disruptions in international money markets and banks reportedly faced severe liquidity shocks, in particular US-dollar funding shortages, prompting central banks around the world to adopt unprecedented policy measures to supply funds to the banks. The turbulence also spilled over to the money market in Hong Kong. A better understanding of the forward-looking information content about funding liquidity risk in the prices of interest-rate derivative instruments is therefore necessary to gauge pressures on systemic liquidity. Using the market prices of the US-dollar LIBOR-overnight index swap (OIS) spread, we estimate the probability of the systemic funding liquidity shock during the crisis period, which deviated from zero on 18 September 2008 to 12%. This provided an early warning signal of the systemic liquidity shock on 29 September 2008 when the interbank market was paralysed and the Federal Reserve authorised a US$330 billion expansion of swap lines with other central banks.