Credit goes to forward rate spreads

Commonly used as an indicator of a bank’s health, the spread between reference rates like Libor and the overnight indexed swap rate used to be close to zero until the onset of the crisis. After many years of high spreads, we know that it is now here to stay and so must be included in pricing models. Christian Fenger suggests a way to do this and gives a theoretical foundation, using a combination of a credit model and a rate-fixing technique

Since the onset of the financial crisis in July 2007, the spreads between expected fixings based on benchmark rates, like Libor and Euribor, and expected overnight indexed swap (OIS) rates have been significant, so it became necessary to involve new methods in the pricing of interest rate derivatives (Bianchetti 2010; Fujii, Shimada and Takahashi 2010; Mercurio 2009; Morini 2009; Piterbarg 2010). A typical picture of this new regime is displayed in figure 1. The figure shows the spreads between