Overnight Index Swap

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Overnight Index Swap is an interest rate swap involving the overnight rate being exchanged for some fixed interest rate. Generally short-term, the interest of the overnight rate portion of the swap is compounded and paid at maturity.

An Overnight Indexed Swap (OIS) is a fixed/floating interest rate swap with the floating leg tied to a published index of a daily overnight rate reference. The term ranges from one week to two years (sometimes more). The two parties agree to exchange at maturity, on the agreed notional amount, the difference between interest accrued at the agreed fixed rate and interest accrued through geometric averaging of the floating index rate.

This means that the floating rate calculation replicates the accrual on an amount rolled “P plus I” at the index rate every business day over the term of the swap. If cash can be borrowed by the swap receiver on the same maturity as the swap and at the same rate and lent back every day in the market at the index rate, the cash payoff at maturity will exactly match the swap payout: the OIS acts as a perfect hedge for a cash instrument. Since indices are generally constructed on the basis of the average of actual transactions, the index is generally achievable by borrowers and lenders. Economically, receiving the fixed rate in an OIS is like lending cash. Paying the fixed rate in an OIS is like borrowing cash. Settlement occurs net on the earliest practical date. There is no exchange of principal.

[edit] Use

The OIS swap can be used to manage interest rate risk for flexible periods, without taking liquidity risk and with minimum credit risk (hence there is efficient usage of capital). This will lead to deeper and more efficient markets.

Since their introduction in the 1990s, Overnight Indexed Swaps have become a widely-used, highly credit-efficient and liquid derivative in all major currencies. They are used to hedge against, or speculate on, moves in overnight interest rates (both ‘micro’ moves — daily volatility — and, more importantly, ‘macro’ moves driven by central banks, who influence overnight rates directly.)

Interest Rate Risk Management
OIS allow the interest rate risk profile of a portfolio to be changed as if by the addition of a cash asset or borrowing but with no use of cash and with minimal use of credit. These features allow much better risk management and separate funding maturity from interest rate duration.