Overnight Index Swap

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on July 12, 2023

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What Is an Overnight Index Swap?

An Overnight Index Swap (OIS) is a derivative contract in which two parties agree to exchange, or 'swap', interest rates over a specified period.

One party will pay a fixed interest rate and receive a floating interest rate, which is pegged to an overnight rate, such as the Fed funds rate in the US. The 'overnight' refers to the continual resetting of the rate based on the index's daily fluctuations.

OIS plays a pivotal role in financial markets as it provides a gauge of market expectations of central bank rates. It can reflect future monetary policy changes and the corresponding market sentiments.

As OIS is a risk-free rate, it is used in various contexts including to value and hedge interest rate risk in derivative portfolios, calculate counterparty risk, and make policy decisions.

OIS emerged in the early 1990s as a tool for banks to manage fluctuations in short-term interest rates. The increased usage of OIS was fueled by the 2008 financial crisis, which highlighted the need to separate credit risk from interest rate risk in interbank lending.

Mechanics of Overnight Index Swaps

Contract Structure

An OIS contract involves two cash flows. One party agrees to pay a predetermined fixed rate of interest on a notional principal amount. In return, they receive a variable interest amount based on the average of the floating overnight rate over the agreed term.

Calculation of Swap Rate

The OIS swap rate is determined by the market and represents the average expected overnight rate over the term of the swap. The actual overnight rate is usually computed using a geometric mean, taking into account the compounded interest effect.

Use in Financial Transactions

In financial transactions, OIS is primarily used to hedge interest rate risk. Banks and other financial institutions utilize OIS to lock in a fixed rate, protecting against potential hikes in the overnight rate. Additionally, it serves as a benchmark for pricing other financial instruments.

Participants in the Overnight Index Swap Market

Financial Institutions

Financial institutions like banks and insurance companies are significant players in the OIS market. They engage in these swaps to manage their interest rate exposure and to speculate on future movements in interest rates.

Hedge Funds and Pension Funds

Hedge funds use OIS to hedge against fluctuations in short-term interest rates, which could affect their investment strategies. Pension funds might use OIS to match their assets and liabilities better, reducing their risk exposure.

Central Banks

Central Banks are not direct participants but influence the OIS market indirectly. They control the short-term interest rate, which is used as the floating rate in OIS contracts.

Participants in the Overnight Index Swap Market

Understanding the Overnight Index Swap Curve

Definition and Use

The OIS curve represents the structure of OIS rates across different maturities, ranging from one day to several years. This curve is crucial in the financial world as it serves as a measure of market expectations for the path of the risk-free interest rate.

Construction and Interpretation

The OIS curve is built from the market prices of OIS contracts of different maturities. A higher rate for longer maturities indicates the market's expectation of an increase in the overnight rate over time, and vice versa.

Differences From Other Yield Curves

Unlike other yield curves that incorporate credit risk, the OIS curve reflects only the expected path of future overnight rates. This is because the short-term nature of overnight rates significantly reduces credit risk.

Pricing and Valuation of Overnight Index Swaps

Basic Principles

The pricing of OIS relies on the principle of no-arbitrage, meaning that the present value of fixed and floating cash flows should be equal at the initiation of the contract.

Determinants of the Swap Rate

The swap rate in OIS contracts is influenced by factors such as the current overnight rate, expected changes in the rate, the term of the contract, and the demand and supply of OIS in the market.

Role of Overnight Index Swaps in Monetary Policy

Transmission Mechanism

The OIS market acts as a transmission channel for monetary policy as changes in central bank rates directly affect the floating rates in OIS contracts, thereby influencing the behavior of financial institutions.

Insights Into Market Expectations

The OIS curve can provide insights into market expectations of future monetary policy changes. Policymakers can use this information to better communicate their intentions and manage market expectations.

Use in Implementing Policy

Central banks can also use the OIS market to implement monetary policy, for instance, by entering into OIS contracts to affect short-term interest rates.

Applications of Overnight Index Swaps

Interest Rate Risk Management

Financial institutions use OIS contracts to manage interest rate risk by swapping variable rate payments for fixed-rate payments, thus stabilizing their net interest income.

Trading Strategies

Traders can use OIS contracts to speculate on future changes in overnight rates, thereby generating profits. For example, if a trader expects the overnight rate to increase, they might enter into an OIS contract paying a fixed rate and receiving a floating rate.

Arbitrage Opportunities

Arbitrageurs can use OIS to exploit discrepancies between the OIS rate and other interest rates, such as the LIBOR-OIS spread, which represents the credit risk in the interbank lending market.

Applications of Overnight Index Swaps

Risk Management in Overnight Index Swaps

Credit Risk

While OIS contracts are generally considered low-risk instruments due to their short-term nature, credit risk can still arise if one party defaults on its obligations.

Market Risk

Market risk in OIS arises from unexpected changes in overnight rates, which can cause losses for parties paying the floating rate.

Operational Risk

Operational risk in OIS includes risks related to contract settlement, documentation, and system failures. Institutions must implement robust risk management processes to mitigate these risks.

Final Thoughts

An Overnight Index Swap is a derivative contract wherein two parties agree to swap interest payments—one pays a fixed rate, and the other pays a rate linked to an overnight index, thus playing a vital role in hedging against interest rate risk and speculation.

OIS serves as a gauge of market expectations for central bank rates, reflecting future monetary policy changes and market sentiments.

OIS is widely used for interest rate risk management, hedging, valuation of derivative portfolios, and as a benchmark for pricing other financial instruments.

The OIS market involves various participants, including financial institutions, hedge funds, pension funds, and central banks.

The construction and interpretation of the OIS curve provide valuable insights into market expectations for the risk-free interest rate path, aiding policymakers in communicating their intentions and managing market expectations.

Overall, the OIS market and its associated instruments contribute significantly to interest rate risk management, trading strategies, and arbitrage opportunities, while necessitating effective risk management practices to address credit, market, and operational risks.

OIS is a sophisticated financial instrument, and its use requires a deep understanding of interest rates and financial markets. Therefore, it is recommended to seek professional advice before engaging in OIS transactions.

Overnight Index Swap FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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