Volatility in the federal funds market and money market spreads during the financial crisis

Abstract

We analyze the role of federal funds rate volatility in affecting risk premium as measured by various money market spreads during the 2007-2009 financial crisis. We find that volatility in the federal funds market contributed to elevated Overnight Index Swap (OIS) spreads of unsecured bank funding rates during the crisis. Using OIS as a proxy for market expectations, we also decompose London Inter-Bank Offered Rate (Libor) into its permanent and transitory components in a dynamic factor framework and show that increased volatility in the federal funds market contributed to substantial transitory movements of Libor away from its long-run trend during the financial crisis.