To understand Overnight Index Swap (OIS) in depth we need to know some basics related to it.

What is Swap?

A swap basically means exchange. So any financial product suffixed or prefixed by words swap would indicate the exchange of something. This something might be future cash flows, interest rates (fixed or floating), currencies or a combination of the above.

What is an Interest rate swap?

An interest rate swap involved the exchange of interest rates. It can be fixed to floating rate swap, floating rate to another floating swap or a fixed to fixed rate swap. It can involved swapping rates in different currencies as well. Quonto Swap and Currency Swap

Overnight Index swap

OIS is a contract involving swapping a fixed rate with a benchmark overnight floating rate.

Features of Overnight Index Swap

  1. OIS involves swapping of only the interest flows, the principal amount is notional, to be used just for calculation of interest rates. Principal is not exchanged.
  2. Payout happens periodically and is the difference between the interest amount calculated as per the fixed rate and the interest rate calculated as per the floating overnight rate.
  3. The floating rate is a benchmark overnight rate and is the geometric average of the floating index rate. This means that the floating rate calculation replicates the accrual on an amount rolled “P plus I” at the index rate every business day over the term of the swap. If cash can be borrowed by the swap receiver on the same maturity as the swap and at the same rate and lent back every day in the market at the index rate, the cash payoff at maturity will exactly match the swap payout. Example will make this point clear.
  4. Tenor of the contract ranges from 1month to 10 year. In India maximum liquidity is in the contract for 1 year.
  5. Borrower of the contract pays a fixed rate of interest to the seller and the seller pays a floating rate to the buyer. The difference between the two amounts is settled on periodically on a pre-specified date.
  6. Day count convention has to be specified. In case nothing is specified, actual/365 is the convention used for calculation of interest rates.

Quotes of Overnight Index Swap

As any stock or derivative, OIS has a bid and ask. Say, quotes for MIBOR-OIS for 12 months are 4.9300 bid to 4.9600 ask, meaning a ready buyer can buy OIS at 4.9600 and a ready seller can sell at 4.9300. This means that a party who buys OIS 1year at 4.9600 agrees to pay 4.96% fixed rate of interest to the seller and in turn receive the overnight MIBOR rate compounded over the period of 1 year. Thus

Buyer/payer of OIS = Pays a fixed rate and receives a floating rate

Seller/receiver of OIS = Receives a fixed rate and pays a floating rate

One contract by default is for Rs 25 crores.

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

Author : Praveen Bajaj, MBA (SCMHRD)

This article is part 1 of the series on Overnight Index Swap. To see second part of Overnight Index Swap series click

Overnight Index Swap – 2

Related posts:

  1. Overnight Index Swap 2 – Pricing of OIS
  2. Overnight Index Swap 3 – Uses of OIS
  3. Interest Rate Floor