Estimating Forward Nibor Premiums

Abstract

Money market premiums show the difference between unsecured money market rates and expected key rates over the same time horizon. The premium expresses the additional return money market participants require for unsecured interbank loans in relation to the risk-free interest rate in a given period. The premium is compensation to the lender for credit risk and the benefit foregone from relinquishing liquidity. Prior to the financial crisis money market premiums were low and stable both in Norway and other countries. They soared in autumn 2008. Even though they have come down somewhat since then, in recent years premiums have been high for long periods and have fluctuated to a further extent than prior to the crisis. As a result, the uncertainty surrounding estimates of future premiums is greater than earlier. Most economies have a market for expected overnight interest rates, or the overnight index swap (OIS). Expected overnight interest rates are closely linked to expected key policy rates. An OIS market makes it possible to extract both premium and key policy rate expectations directly from market prices. Norway does not have such an OIS market. Norges Bank still seeks to provide some indication of the market’s key policy rate expectations and the market’s pricing of expected money market premiums. The market’s key policy rate expectations can be used to assess any deviations from Norges Bank’s own key policy rate path. The market’s premium expectations are of interest as the premium influences the level of market interest rates and hence the monetary policy transmission mechanism; the channel from the key policy rate to market rates with longer maturities, to real variables and to inflation. Moreover, money market premiums are an indicator of the degree of stress in financial markets. Expected money market premiums are referred to as forward premiums. In this Commentary, we take a closer look at approaches to estimating forward premiums using market prices.