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I have a question linked to the EURIBOR – EONIA spread (or OIS LIBOR spread).

I understand that the EURIBOR - EONIA spread is a credit risk indicator of the interbank market.

There is something I do not understand about the EONIA/OIS swap rate: We say that this rate does not incorporate any credit risk because in the EONIA swap there is no exchange of principal (unlike EURIBOR), therefore no credit risk exposure.

However, if we take the spread between 3-month EURIBOR versus the 3-month EONIA swap rate, the latter is calculated based on the compounded EONIA rate for the 3 month tenor. And the EONIA rate is the unsecured overnight lending rate (with the assumption of exchange of principal).

Therefore, by definition, the EONIA rate, just like EURIBOR, incorporates credit risk (unsecured overnight lending rate). So why would the EONIA swap rate not incorporate such credit risk if it is based on EONIA rate? Saying that the EONIA swap rate is risk free because there is no exchange of principal does not make sense to me.

Thanks for your help.

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  • $\begingroup$ My question relates more to why do some people mention the fact that EONIA swaps do not entail exchange of principals to justify the low credit risk of the EONIA swap rate? For me, mentioning that there is no exchange of principal is not relevant given that the EONIA swap rate is based on the EONIA index, which is itself based on unsecured lending (therefore with the assumption of notional exchange). I therefore see a contradiction. $\endgroup$ – GuillaumeB Oct 30 '19 at 10:52
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The EONIA rate is linked to overnight unsecured lending for a one-day period. The 3M EONIA rate is linked to continuous rolling of O/N unsecured loans for a 3M period.

THE IBOR rate is linked to unsecured lending for a longer tenor period.

Both incur credit risk as both represent unsecured lending over a tenor period, and in different currencies have different structural mechanisms for calculation of either OIS or IBOR.

Darbyshire 'pricing and trading interest rate derivatives' has a section on this, where he describes the basis (OIS-IBOR spread) of the two as being linked to the availability of free cash and the option embedded with the lender who chooses to 'roll' the shorter term loans rather than initially choosing to adopt a fixed longer term. This is the true nature of the credit risk indicator; nothing more. He builds a model with quite a reasonable outcome, and it also accounts for the structural calculation differences and other regulatory effects such as <1M loans versus >1M loans due to the Basel LCR impact.

I would highlight to all that your comment about EONIA-SWAP rate and EURIBOR-Reference rate being different credits is completely irrelevant and a red herring. You have the following:

  • EONIA/OIS - ref rate: based on unsecured overnight lending.
  • IBOR - ref rate: based on unsecured term lending.
  • OIS-SWAP - derivative: collateralised contract for speculation / risk management on OIS ref rate.
  • IRS or FRA - derivative: collateralised contract for speculation / risk management of IBOR ref rate.
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  • $\begingroup$ I agree with you. Eonia itself has one day credit risk. That risk is incorporated in Eonia swaps. The credit risk of the swap itself (which is negligible) is not relevant. $\endgroup$ – dm63 Oct 31 '19 at 10:24
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It’s not entirely risk-free. Nothing in life is. The comet could hit etc.

The difference is suppose I had a 100m OIS swap line open with Lehman, margined overnight. OIS settles at 1.81% vs 1.80%; and I’m paying. I’m owed 1bp on 100m that I’m not going to get, equals 10 grand. No tears required.

If I had lent 100m to them, my lawyers and ops people would be working a busy weekend, probably to no avail. Maybe the unsecured borrowers recover a few cents on their dollar, a few years down the line.

The issue is one of magnitude more than academic “riskless” vs “risky”.

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Thank you very much. Therefore I would like to summarise my understanding as follows. Let me know if there are still mistakes.

The 3M EURIBOR is an index directly observable in Bloomberg/Reuters. This is not the case for the 3M EONIA. Therefore, to compare the two index on a three month basis, we have to look at a 3 month swap based on an EONIA fixing. The 3M EONIA swap rate will give a fixed rate representing the market expectations of the compounded EONIA rate over a 3 month period. In addition, the swap contract will bear only very limited credit risk as there is no principal exchange and that swap is margined with collateral. Therefore, no additional credit risk emanating from the derivative will come blur the EONIA information.

The spread between the 3-month Euribor and the compounded Eonia rate of the same tenor will therefore give a sense of the perceived credit risk, in the interbank market, between an unsecured lending over 3 months and an unsecured overnight lending rolled for 3 month, where in the latter there is the option for the investor to step out every day.

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  • $\begingroup$ Thats correct, and I would add that if you consider the forward basis, i.e. for 3M periods starting in the future, then the 3M EURIBOR rate has not been published in which case you will be referencing an FRA vs a 3M OIS swap, which is comparing a derivative with a derivative. Forward basis is the more common measure since it is the market expectation of every future date, whilst the 'spot' basis only exists for one single date, i.e. the first one. $\endgroup$ – Attack68 Nov 1 '19 at 6:26

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