How to gauge fear in the markets

Markets are driven by two key emotions: greed and fear. If you want to be successful, as Warren Buffett once said, you should "be fearful when others are greedy, and be greedy when others are fearful".

In other words, you want to be buying when people are scared stiff, and selling when they're overly complacent. But how can you measure the level of fear in the markets? Here are three of the most useful early warning signs used by City insiders.

The Libor-OIS spread

Retail banks remain central to the modern economy, despite the battering the sector's reputation has taken in recent years. That's because they pull off a clever trick, without which businesses couldn't borrow and you and I could not get a mortgage: they take short-term deposits and turn them into long-term loans. It's not without risk, as Northern Rock demonstrated when the money markets dried up in 2007, but it is a vital function.

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So, trouble in the banking sector means there's trouble brewing elsewhere. You can spot early signs of this by watching the gap between the interest rates called Libor (the London Inter-Bank Offered Rate) and another called the OIS (Overnight Index Swap) rate.

In financial markets, a gap between two rates (or prices) is usually known as a spread'. Libor is in the press just now because banks are accused of rigging it (see my video for more).

However, it's still a key benchmark for lending rates, with trillions of dollars worth of contracts, ranging from commercial loans to mortgages, priced off it. It represents the average rate at which the main UK banks think they can borrow over time periods ranging from overnight to 12 months. The three-month rate is the most common.

The next part of the signal is the OIS. Without going into the gritty details, an overnight index average interest rate, such as Sonia (the sterling version), is the average rate that banks think they'll have to pay to leave funds on deposit overnight. A typical OIS swap is a contract based on what the market expects the compound overnight rate to be over the next three months (if you added up three months' worth of expected overnight rates).

Now for the key point the spread. When the market is calm, the two rates tend to be similar after all, why would the compounded overnight rate be much different to the three-month lending rate? With zero default risk, if a big gap existed, you'd just keep borrowing at the OIS rate, lend at Libor, and take a risk-free profit (this is called arbitrage).

But when banks are nervous they want to deposit funds for the shortest possible time and overnight is about as short as it gets. It's highly unlikely a counterparty will go bust in that time. However, a decision to lend for three months at the Libor rate is a riskier bet. So when banks are nervous of lending to one another, Libor shoots up and the spread with the OIS rate rockets.

The spread was ticking along at about ten basis points (there are 100 basis points to a percentage point) until early 2007. Then it started to leap and hit a peak of 350 basis points (a 35-fold jump!) as Lehman Brothers declared bankruptcy.

Now it's back down to around 30 basis points, but that's still three times its long-term average. The spread has been creeping up this year. In other words, fear still stalks the banking sector. You can get the latest reading from a Bloomberg terminal or by just searching Libor-OIS in Google News most days.

CDS spreads

Most drivers reading this will have car insurance. You pay a premium in return for cover should a specified event (you crash, or your car is stolen) take place. In financial markets a credit default swap (CDS) does a similar job, with two key differences.

First, you don't have to be a registered insurer to write and sell one so in theory, I could and so could you. That's a little scary but we'll leave it to regulators to ponder. More importantly it does a different job the buyer pays a premium for protection should a credit event' take place, say, a bond (IOU) they hold defaults. The CDS seller then typically pays a cash lump sum in compensation.

How does this help us measure fear? Just as high-risk drivers pay more for car insurance so high-risk bonds attract a higher CDS premium. For example, the cost of insuring against a Greek government IOU defaulting versus a German one is now much higher than before the eurozone crisis began.

Again, the spread is measured in basis points, since this is how premiums are quoted. If a CDS premium is 240 basis points, it would cost you 2.4% of the insured amount (say £100m of UK bonds) to insure against default (with an assumed recovery rate of, for instance, 40%, since the holder might expect to get at least something back).

At the end of last week, according to Dbresearch.com, it cost 91 basis points (just under 1% of the insured amount) to insure German government bonds over five years, compared to 176 basis points to insure French bonds. So the spread is 85 basis points.

The bigger the gap, the riskier France is perceived to be relative to Germany. Greece carries a premium of 23,389 basis points to create a spread over Germany of 23,298, or just over 23% unsurprisingly Greece is still viewed as incredibly risky! But what's also interesting is that compared to, for example, America (49bp), so is France.

The Vix

The Vix is the Chicago Board Options Exchange fear gauge'. It captures in a single number the price options traders are willing to pay to protect against a fall in the value of the S&P 500. The higher that price, the higher the Vix and the higher the fear factor.

This indicator has been as high as 80 or more, but typically sits nearer 13. Right now it is at around 18, which suggests a degree of complacency in equity markets. This indicates that, for now, it's probably worth maintaining a defensive stance, rather than grabbing an opportunity to hunt for bargains. You can check the Vix here.