Overnight Index Swaps

Overnight Index Swaps

Overnight index swaps (OIS) are interest rate swaps. There is an active and liquid market for these swaps going out two years and beyond depending on currency. The notional sizes dealt can be much larger than for fixed rate - Libor swaps. The trade is based on a notional amount (no exchange of principle) this is used in the calculation of the interest payments.

One party pays a fixed rate of interest. The other pays a variable rate. The variable rate is linked to the unsecured overnight rate. For example, the Fed Funds rate, Euro Overnight Index Average (EONIA) or Sterling Overnight Index Average (SONIA).  The overnight rate is compounded daily.  At the end of the deal the fixed payment is netted out with the floating payment.

Traditionally banks have used interest rate swaps to convert their assets and liabilities to Libor. In this way, they mitigate their interest rate risk. OIS take this a step further. They allow banks to swap their interest payments and receipts back to an overnight rate and further reduce mismatches in their balance sheet.

A “Risk-free” rate

At the start of the transaction, assuming midmarket pricing, the value of an OIS should be nil. This means that the fixed rate on the OIS should have an equal and opposite present value to the compounded overnight rates.

Because it is assumed that the overnight rate is largely risk free (it is closely linked to the Central Bank Repo Rate which is a collateralised rate) it implies that the fixed OIS rate is also largely free from credit risk. The OIS rates therefore provide yield curve that strips out the risk of the banking system.

3 Month Libor - 3 month OIS rates

The 3 month Libor rate is an average funding cost for banks. The 3 month OIS rate equates to the cost of daily re-financing.

As the market’s perception of bank credit risk increases the cost to banks’ of three month money increases and 3 month Libor increases. The OIS rate does not change in the same way. This is because it is based on the overnight borrowing cost which less sensitive to credit risk.

The difference between the 3 month Libor rate and the 3 month OIS rate therefore tells us about the market’s perception of stress or risk in the financial system. During the 2007/8 crisis the difference between 3 month Libor and 3 month OIS moved from 10-50 basis points to 350 basis points, (Libor 350 basis points higher than the OIS rate).

Not only can this “credit-spread” act as a barometer it is instrumental in changing our approach to valuation. Moving from Libor based curves to ones based on OIS rates.

OIS Discounting

OIS discounting has been adopted by many practitioners to value collateralised swaps (some also include uncollateralised trades). This is because collateral or margining substantially reduces counterparty credit exposure. The argument is that once margined the cash flows from the swap are largely risk free therefore is in appropriate to value them using a Libor based swap curve. They should be valued using a curve that is also risk free.

Proprietary pricing models use the OIS term structure to bootstrap a zero-coupon discount factor in a similar way to using a Libor based swap curve.

Short term interest rate futures can also be added (with the implied Libor rates being adjusted downwards) for the Libor-OIS spread.

For longer dated rates the Libor swap curve may be adjusted downwards by extrapolating Libor-OIS spread from earlier maturities or by factoring in the Libor – OIS basis swap price. How you do this is subjective.

First Published by Barbican Consulting Limited 2017