Overnight Index Swaps

Overnight Index Swaps (OIS) is an important concept to understand because the OIS plays a vital roll in a market indicator that many economists and analysts watch every day to determine the health of the credit marketsthe LIBOR OIS spread. So let's take a look at what the OIS is all about.

Overnight Index Swaps (OIS)

Overnight Index Swaps (OIS) are instruments that allow financial institutions to swap the interest rates they are paying without having to refinance or change the terms of the loans they have taken from other financial institutions. Typically, when two financial institutions create an overnight index swap (OIS), one of the institutions is swapping an overnight interest rate and the other institution is swapping a fixed short-term interest rate. This may sound a bit strange, but here is how it works.

Imagine Institution #1 has a $10 million loan that it is paying interest on, and the interest is calculated based on the overnight rate. Institution #2, on the other hand, has a $10 million loan that it is paying interest on, but the interest on this loan is based on a fixed, short-term rate of 2 percent. As it turns out, Institution #1 would much rather be paying a fixed interest rate on its loan, and Institution #2 would much rather be paying a variable interest ratebased on the overnight rateon its loan, but neither institution wants to go out and get a new loan and they can't renegotiate the terms of their current loans. In this case, these two institutions could create an overnight index swap (OIS) with each other.

To set up the swap, both institutions would agree to continue servicing their loans, but at the end of a specified time periodone month, three months and so onwhoever ends up paying less interest will make up the difference to the other institution. For example, if Institution #1 ends up paying an average interest rate of 1.7 percent on its loan and Institution #2 ends up paying an interest rate of 2 percent, Instititution #1 will pay Institution #2 the equivalent of 0.3 percent (2.0 - 1.7 = 0.3) because, according to their agreement, they swapped interest rates. Of course, if Institution #1 ends up paying an average interest rate of 2.2 percent on its loan and

Institution #2 ends up paying an interest rate of 2 percent, Instititution #2 will pay Institution #1 the equivalent of 0.2 percent (2.2 - 2.0 = 0.2) because, according to their agreement, they swapped interest rates.

The overnight index swap (OIS) market is quite large, and the movements in this market can provide a lot of information for economists and analysts who are trying to understand what is happening in the global financial markets. One of the key pieces of information analysts watch is the interest rate the institutions who have loans with variable interest rates are paying.

The question is, how do you determine what rate to use when each institution is paying a slightly different rate based on what time of day they have to determine their payment. You see, the overnight rate in constantly changing, and you will pay a different interest rate at 6:00 am than you will pay at 11:00 am.

To resolve this issue, an overnight index swap rate is calculated each day. This rate is based on the average interest rate institutions with loans based on the overnight rate have paid for that day.

What Does the Overnight Index Swap Rate Tell Us?

By itself, the overnight index swap rate doesn't tell us muchother than what the overnight rate is. However, when you combine the overnight index swap rate with another indicator, like LIBOR, and create a spread like the LIBOR OIS spread, you can get a glimpse into the health of the global credit markets. LIBOR-OIS Spread

The LIBOR-OIS spread is a comparison between the London Interbank Offered Rate (LIBOR) and the overnight index swap (OIS) rate. You see, analysts aren't too concerned with the nominal value of each of these rates. What they are concerned with is the relationship between these two rates. Typically, LIBOR is higher than the overnight index swap rate, but knowing that alone isn't enough. You need to know what the spread is.

To calculate the LIBOR-OIS spread, you simply subtract the overnight index swap rate from the three-month LIBOR rate. For instance if the three-month LIBOR rate is at 3.25 percent and the overnight index swap rate is at 2.50 percent, the LIBOR-OIS spread is 0.75 percent, or 75 basis points (3.25 - 2.50 = 0.75).

To get an idea of how the spread between these two numbers can widen and contract, take a look at the following two

What Does the LIBOR-OIS Spread Tell Us?

Okay, now we know how to calculate the LIBOR-OIS spread, but what exactly does it tell us?

Increasing LIBOR-OIS Spread

When the LIBOR-OIS Spread is increasing, it tells us that banks believe the other banks they are lending to have a higher risk of defaulting on the loans so they are charging a higher interest rate to offset this risk. It also tells us that the credit markets are not functioning as smoothly as they could bewhich is sign of potential economic contraction.

Decreasing LIBOR-OIS Spread

When the LIBOR-OIS Spread is decreasing, it tells us that banks believe the other banks they are lending to have a lower risk of defaulting on the loans so they are charging a lower interest rate to offset this risk. It also tells us that the credit markets are functioning smoothlywhich is sign of potential economic expansion.

Example

INR 219,125,000 is swapped between floating rate and fix rate, the cash flows between Cpty and PO should match at specified frequency, so who ever pays less interest will pay to other Cprt SA in below case.