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Understanding Overnight Index Swaps
10/31/2008 11:15 am EST
Why Should You Care About the OIS?
Overnight Index Swaps (OIS) are not exactly a topic that comes up a lot in dinner-party conversation. In fact, it is probably not a term that comes up in a lot of conversations about the financial markets. However, it is an important concept to understand, because the OIS plays a vital roll in a market indicator that many economists and analysts watch every day to determine the health of the credit markets—the LIBOR OIS spread.
Overnight Index Swaps
Overnight Index Swaps are instruments that allow financial institutions to swap the interest rates they are paying without having to refinance or change the terms of the loans they have taken from other financial institutions. Typically, when two financial institutions create an overnight index swap, one of the institutions is swapping an overnight interest rate and the other institution is swapping a fixed, short-term interest rate. This may sound a bit strange, but here is how it works.
Imagine institution A has a $10 million loan that it is paying interest on, and the interest is calculated based on the overnight rate. Institution B, on the other hand, has a $10 million loan that it is paying interest on, but the interest on this loan is based on a fixed, short-term rate of 2%. As it turns out, institution A would much rather be paying a fixed interest rate on its loan, and institution B would much rather be paying a variable interest rate‚ based on the overnight rate on its loan‚ but neither institution wants to go out and get a new loan, and they can't renegotiate the terms of their current loans. In this case, these two institutions could create an overnight index swap with each other.
To set up the swap, both institutions would agree to continue servicing their loans, but at the end of a specified time period; one month, three months, and so on; whoever ends up paying less interest will make up the difference to the other institution. For example, if institution A ends up paying an average interest rate of 1.7% on its loan, and institution B ends up paying an interest rate of 2%, institution A will pay institution B the equivalent of 0.3% (2.0 - 1.7 = 0.3) because, according to their agreement, they swapped interest rates. Of course, if institution A ends up paying an average interest rate of 2.2% on its loan and institution B ends up paying an interest rate of 2%, institution B will pay institution A the equivalent of 0.2% (2.2 - 2.0 = 0.2) because, according to their agreement, they swapped interest rates.
Overnight Index Swap Rates
The overnight index swap market is quite large, and the movements in this market can provide a lot of information for economists and analysts who are trying to understand what is happening in the global financial markets. One of the key pieces of information analysts watch is the interest rate the institutions that have loans with variable interest rates are paying.
The question is, how do you determine what rate to use when each institution is paying a slightly different rate based on what time of day they have to determine their payment? You see, the overnight rate in constantly changing, and you will pay a different interest rate at 6:00 am than you will pay at 11:00 am. To resolve this issue, an overnight index swap rate is calculated each day. This rate is based on the average interest rate institutions with loans based on the overnight rate have paid for that day.
What Does the Overnight Index Swap Rate Tell Us?
By itself, the overnight index swap rate doesn't tell us much‚ other than what the overnight rate is. However, when you combine the overnight index swap rate with another indicator, like LIBOR, and create a spread like the LIBOR OIS spread, you can get a glimpse into the health of the global credit markets.
S. Wade Hansen is a founder of LearningMarkets.com and PFXGlobal.com. He is also the co-author of Profiting With Forex, a popular currency investing book. His commentary is featured on financial sites across the web.
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