What Is an Overnight Index Swap (OIS)?
Let me explain what an overnight index swap is—it's a financial contract you use to manage interest rate risk. In this agreement, one party pays a fixed interest rate, and the other pays a floating rate based on an overnight index.
You should know that an index swap is essentially a hedging contract where one party exchanges a predetermined cash flow with a counterparty on a specified date. Here, a debt, equity, or other price index serves as the basis for one side of the swap.
Specifically, an overnight index swap applies an overnight rate index, such as the federal funds rate. These are specialized versions of conventional fixed-rate swaps, with terms ranging from three months to more than a year.
Key Takeaways
The interest on the overnight rate portion of the swap gets compounded and paid at reset dates, while the fixed leg is accounted for in the swap's value to each party.
You determine the floating leg's present value by either compounding the overnight rate or taking the geometric average over a given period.
Just like other interest rate swaps, you need to produce an interest rate curve to figure out the present value of the cash flows.
How Does an Overnight Index Swap (OIS) Work?
In an overnight index swap, you exchange the overnight rate for a fixed interest rate. The underlying rate for the floating leg is an overnight index like the federal funds rate, and the fixed leg is set at a rate both parties agree on.
The interest from the overnight rate part is compounded and paid at reset dates, with the fixed leg factored into the swap's value for each side.
To find the present value of the floating leg, you either compound the overnight rate or use the geometric average over the period.
Financial institutions favor overnight index swaps because the overnight index is a solid indicator of interbank credit markets and carries less risk than traditional interest rate spreads.
How to Calculate an Overnight Index Swap
Calculating the benefit from an overnight index swap involves eight steps, and I'll walk you through them directly.
First, multiply the overnight rate by the period the swap covers. If it starts on a Friday, that's three days since weekends don't settle; otherwise, it's one day. For example, with a 0.005% rate on Friday, the effective rate is 0.015% (0.005% x 3).
Next, divide that effective rate by 360—industry standard uses 360 days a year. So, 0.005% / 360 equals 1.3889 x 10^-5.
Then, add one to that result: 1.3889 x 10^-5 + 1 = 1.000013889.
Multiply this by the loan principal, say $1 million, giving 1.000013889 x $1,000,000 = $1,000,013.89.
Apply these calculations daily for multi-day loans, updating the principal as rates vary.
For steps six and seven, divide the swap rate by 360 and add 1. If the rate is 0.0053%, it's 0.0053% / 360 + 1 = 1.00001472.
In step eight, raise this to the power of the loan days and multiply by principal: 1.00001472^1 x $1,000,000 = $1,000,014.72.
Finally, subtract the sums to find the profit: $1,000,014.72 - $1,000,013.89 = $0.83.
What Is an Overnight Index Swap?
Think of an overnight index swap as a bet on short-term interest rate directions. One party pays a fixed rate, the other a floating rate based on the overnight index. At the end of the period, one pays the difference between fixed and floating rates.
Why Does Anyone Undertake an Overnight Index Swap?
Financial institutions and large enterprises use these swaps to hedge against sudden swings in short-term rates, locking in their costs. Traders and speculators jump in when they anticipate rate changes.
Is an Overnight Index Swap a Derivative?
Yes, it's a type of derivative contract based on short-term rates without representing an actual asset investment.
The Bottom Line
Overnight index swaps are mainly an interbank tool for hedging against interest rate shifts. Hedge fund managers and speculators also use them to bet on short-term rate movements.
