Libor and the OIS

These are two of the most important interest rates in the world. Libor is the London Interbank offered rate. This is published by the British Banking Association based on averaging the rates at which major British banks are prepared to lend to each other.

The higher Libor is in relation to the Bank of England rate, the more nervous these banks are of each other. It is also used as the basis for pricing variable-rate mortgage products and commercial loans (for example, a company might be asked to pay a rate of, say, Libor+1%, depending on its credit rating).

In the US, the overnight index swap (OIS) is a broadly comparable rate, although it is calculated differently. It represents the average fixed rate US banks are prepared to offer in exchange for a short-term floating (ie, variable) rate of interest (called a swap). These swaps allow borrowers to hedge their exposure to rising rates.

The gap between Libor and the OIS is called the Libor/OIS spread and is another useful fear guage.

• See Tim Bennett’s video tutorial: Libor: Britain’s most important interest rate.

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