This article is part 2 of the series on Overnight Index Swap. To see first part of Overnight Index Swap series click

Overnight Index Swap – 1

Pricing of OIS

Pricing involves calculating the fixed rate of interest for a given floating rate benchmark. This pricing can be done on the basis of term money rates prevailing in the interbank market or on the basis of yields on G-Sec or corporate bonds.

Example

For simplicity sake, lets take a 7-day OIS, where counterparty A agrees to pay another counterparty B a fixed rate of 7% pa and receive overnight MIBOR on a notional principal of Rs 25 cr.

Floating rate leg

Interest is calculated on a daily basis as shown below.

Overnight MIBOR rate for these days is given in third column. In the above example we have assumed that day 3 is a public holiday thus interest for Day 2 and 3 are calculated simultaneously taking the rate of day 2.

Total interest accrued on floating rate leg is Rs 377,081 as shown above.

Alternatively, this interest can be calculated by compounding the daily rates for the each day. In this case the compounded rate over 7 days is 0.1508% for 7 days or 7.86% pa.

Fixed leg interest

At 7% pa, the interest for 7 days is Rs 335,616.

Thus A, which was to receive floating rate of interest will receive Rs 335,616 from B, which was paying floating rate and receiving fixed rate. By looking at the rates as well we can calculate the amount of payout. Floating interest rate is 7.86% and fixed interest rate is 7%, A will receive the difference amount from B.

Reversal/ Cancellation of contract

There are two ways in which the OIS contract can be cancelled-

1. By entering into a reverse contract for the remaining tenor. For instance, in the above example, if A wants to reverse the contract on day 4, it can sell a contract for 3 days i.e enter into a contract to receive fixed and pay floating for 3 days ending on day 7. Notional principal in this case would be the original amount plus accrued interest for 4 days on the basis of floating rate. This method, however, is credit and capital inefficient as it involves booking extra credit limit for a reverse swap whereas cancellation of the outstanding swap would release credit limits
2. By canceling the contract. This involves payout of funds for the interest differential for the period from start date to cancellation date and payout for cancellation premium which is calculated on the basis of the cancellation rate given by the counterparty.

In next article related to Overnight Index Swap we will discuss about the uses and various risk associated with Overnight Index Swap (OIS).

Author : Praveen Bajaj, MBA (SCMHRD)

Related posts:

1. Overnight Index Swap (OIS) – 1
2. Overnight Index Swap 3 – Uses of OIS
3. Interest rate Derivatives: Cap