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. A better understanding of the forward-looking information content about funding liquidity risk in interest rate derivative prices is therefore necessary to gauge pressures building surrounding systemic liquidity. Using the market prices of the US dollar LIBOR-overnight index swap spread, we estimate the probability of the systemic funding liquidity shock during the crisis period, which deviated from zero on 17 September 2008 to a significant level. This provided an early warning signal of the systemic liquidity shock on 29 September 2008 when the interbank market was totally paralysed. Copyright Springer Japan 2013