This article is part 3 of the series on Overnight Index Swap. To see first part of Overnight Index Swap series click

Overnight Index Swap – 1

Overnight Index Swap – 2

Users of Overnight Index Swap

As per RBI guidelines, banks, financial institutions, primary dealers and corporate have been allowed to transact in OIS

Uses of Overnight Index Swap

Asset liability management

Many a times banks and other institutions run asset liability mismatch such as having cash surplus with long term liabilities and lacks assets. Thus they have to lend overnight resulting in lesser returns on funds and runs the risks of fluctuations in overnight rate. This can be mitigated by OIS. It can sell and OIS thus receiving fixed rate and pay O/N rate and continue to lend in overnight market. Thus the risk is mitigated at the same time results in higher returns and liquidity to the institution.

Hedging interest rate risks

Banks, primary dealers and institutions all run interest rate risks which can be managed with OIS. Primary dealer typically fund securities positions in overnight markets and thus run asset liability mismatches and are exposed to volatility in overnight rates. OIS offers the opportunity to hedge interest rate risk and reduce asset liability mismatches. A PD buys bonds and to pay for them borrows in O/N market and thus is exposed to interest rate risks. In order to mitigate, PD pays fixed and receives floating on the OIS. It still borrows in call and retains flexibility in position management

Cash management tool

Financial institutions and some corporate allocate surplus cash in liquid assets like overnight deposits for maintaining liquidity. Through an OIS, these entities can still lend overnight and keep their liquidity but lock into a term rate thus enhancing the returns on funds deployed.

Reduction of interest cost

If any institution has a receivable or payable at fixed rate of interest but is of the view of increase or decrease in interest cost, it can use OIS to change the term of asset or liability. For instance, a corporate has an outstanding fixed rate loan with a residual tenor of 1 year. It has a view that interest rates will remain stable or decline and hence, is concerned about his high fixed rate loan. One of the alternatives is he can either repay the fixed rate loan and raise a fresh loan via a MIBOR linked bond. But this was involves paying a prepayment penalty and paying processing charges on the new loans which sometimes can be very high. Instead he can enter into an OIS where it receives a fixed rate and pays MIBOR. This way replicates Alternative 1 but more efficiently.

Carry trade

OIS transactions make an excellent tool for the so-called carry trade on the short end of the yield curve. If the dealer decides that the overnight forward curve is too flat and expect that it will become steeper, it can pay/buy OIS (they pay a fixed rate by receiving a floating one). If, however, the trader believes that this curve is too steep and expect it to become steeper, they can sell OIS by receiving a high fixed rate and paying a floating rate which (at least according to his expectations) drops every day.

Predictive capacity of the rates

OIS rates can be used for prediction of rates in two ways.

1. First since OIS quotes involve determination of fixed rate one is willing to offer in exchange for overnight rates, they give an indication of expectation of participating entities regarding the interest rates. If OIS rates for a particular tenure rise, participants are expecting the O/N rates for that particular tenure to rise. Again the spread of various OIS rates for different tenure give similar indications.

2. Former Federal Reserve chairman remarked about the LIBOR-OIS spread “Libor-OIS remains a barometer of fears of bank insolvency.” This is the second way in which OIS can be used for prediction.

London interbank offer rate (Libor) is the rate at which banks indicate they are willing to lend to other banks for a specified term of the loan.

OIS rate is a measure of the market’s expectation of the overnight funds rate over the term of the contract. There is very little default risk in the OIS market because there is no exchange of principal; funds are exchanged only at the maturity of the contract, when one party pays the net interest obligation to the other.

Thus the term Libor-OIS spread is assumed to be a measure of the health of banks because it reflects what banks believe is the risk of default associated with lending to other banks. OIS spread reflect changes in risk premiums rather than changes in liquidity premiums— premiums that reflect banks’ desire for liquidity. If banks are liquidity constrained, the overnight rate will rise faster than OIS because of inclusion of risk premium in the O/N rate. Considering the LIBOR-OIS spread, from the following diagram, we can see that There was a sharp rise in the term spreads on August 9, 2007, after a lengthy period of being small and relatively constant. Indeed, there was little difference in the spreads across terms of the assets. These term spreads fluctuated around a much higher level until September 17, 2008, following the announcement that Lehman Brothers had filed for Chapter 11 bankruptcy. The spreads increased to very high levels—about 350 basis points—for a period after the Lehman announcement, but have subsequently narrowed. It appears that the spreads reflect the market’s perception of increased risk endemic to the economy more generally.


Related posts:

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