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

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

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