Posts tagged interest rate swap
Overnight Index Swap 3 – Uses of OIS
This article is part 3 of the series on Overnight Index Swap. To see first part of Overnight Index Swap series click
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.
Overnight Index Swap 2 – Pricing of OIS
This article is part 2 of the series on Overnight Index Swap. To see first part of Overnight Index Swap series click
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-
- 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
- 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)
Overnight Index Swap (OIS) – 1
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 More >
