Overnight Index Swaps (OIS)

Overnight Index Swaps (OIS) are interest rate swaps based on a specific currency that exchanges fixed rate interest payments for floating rate payments based on a notional swap principal at regular intervals over the life of the swap contract. The floating rate is based on a specified published index of the daily overnight rate for the OIS currency. For swaps based on the United States dollar (USD), the referenced floating rate is the daily effective federal funds rate.

Introduced in 1995, overnight index swaps are used to either hedge or speculate on changes in the overnight interest rate. As a hedge, overnight index swaps are used manage interest rate risk and liquidity. The terms of OISs range from 1 week to 2 years or more, with spreads typically ranging from 1.5 to 5 basis points. At maturity, the parties determine the net payment by calculating the difference between the accrued interest of the fixed rate and the geometric averaging of the floating index rate on the notional swap principal. Because there is no exchange of principal and only the net difference in interest rates is paid at maturity, OISs have little credit risk exposure.

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The LIBOR-OIS spread is the difference between the LIBOR and the overnight index swap rate that is commensurate with credit risk in the interbank lending market. Ordinarily, both the LIBOR and the OIS rates decline when central banks lower their interest rates. However, when the creditworthiness of borrowing banks is in doubt, lending banks charge higher interest rates as compensation for the greater risk. The LIBOR-OIS spread indicates credit risk in the interbank lending market better than the LIBOR itself because the LIBOR is also influenced by the rates set by central banks.

Because the overnight index swap rate is based only on the rates set by central banks, subtracting it from the LIBOR shows the risk premium being charged for the credit risk.

In this 3-year graph of the 1-month LIBOR-OIS spread for the United States dollar (USD), the marked increase in the difference of the 2 rates is evident starting at the beginning of the Credit Crisis in August, 2007, with a wider spread in September, October, and November of 2008 indicating worsening conditions. As you can see in the graph, prior to August, 2007, both the LIBOR and the OIS rates were high because the Federal Reserve, which is the central bank of the United States, raised their rates. After the beginning of the credit crisis, the Federal Reserve started lowering rates, and the OIS rate has declined with it. The LIBOR, however, has declined sporadically and not nearly as much as the OIS rate, because banks couldn't be sure which banks were creditworthy; hence, they charged higher interbank lending rates, which is what the LIBOR measures.
Bloomberg.com: Investment Tools
http://www.bloomberg.com/apps/cbuilder?ticker1=USSOA%3AIND
Screen clipping taken: 11/30/2008
Here's an updated graph ending on March 19, 2009.

Bloomberg.com: Investment Tools

http://www.bloomberg.com/apps/cbuilder?ticker1=USSOA%3AIND

Screen clipping taken: 3/20/2009, 12:02 AM