Overnight Index Swap (OIS)
Overnight Index Swap (OIS) is the type of a swap in which an overnight rate is exchanged for a fixed interest rate. The overnight rate index is used in hedging contracts where one party exchanges a predetermined asset with the other on a specified date. The agreed exchange for this swap is a debt, equity, or other index. Index swaps are specialized groups of regular fixed rate swaps that can have maturities ranging from three months to over a year.
The overnight index rate can be the federal funds rate as the base rate in the floating portion, while the fixed portion will be set at a rate agreed by both parties. The overnight swap interest rate is added up and paid on the due date, with a fixed portion included in the swap value for each side. The present value of the floating part is determined by adding the overnight rate or the geometric average of the rate for a certain period.
If a commercial bank or company wants to convert a floating rate to fixed rate payments, or vice versa, they can “swap” the interest liability with a counterparty. For example, an organization in the United States may decide to exchange a floating rate, the effective federal funds rate, for a fixed rate OIS.
Over the past 10 years there has been a significant shift towards OIS for some derivatives transactions. Since the transaction does not exchange the underlying asset value, the risk of default in the OIS market is very low. For a long time, all financial market participants did not pay attention to the difference between the LIBOR and OIS rates. However, during the crisis in 2008 LIBOR skyrocketed, which attracted attention. Today the Libor-OIS spread (difference) is considered to be a key indicator of credit risk in the banking sector, as it reflects the risk of default associated with lending to other banks, as LIBOR is the interest rate for a loan from commercial banks in London. The change in the Libor-OIS spread is largely reflected in the change in the risk premium rather than the change in the liquidity premium.
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