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.
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.