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

• We show that higher risk premium as measured by the OIS spreads of unsecured funding rates can be attributed in part to increased volatility in the federal funds market.
• We uncover an additional aspect of risk premia that is not fully reflected in commonly used measures of credit and liquidity risk.
• Our results have implications for the design of operational frameworks for monetary policy.

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.