Overnight Index Swap (OIS) Explained: 2025 Pricing & How to Calculate

Gordon Scott has over 20 years of experience as an investor and technical analyst, holding the Chartered Market Technician (CMT) designation.

What Is an Overnight Index Swap (OIS)?

An Overnight Index Swap is a financial derivative used to hedge interest rate exposure. It involves exchanging cash flows where one party pays a fixed interest rate, and the other pays a floating rate tied to an overnight index such as the federal funds rate.

This swap typically spans from three months up to several years, offering a flexible instrument for managing short-term interest rate risk.

Key Points to Remember

• Interest on the floating overnight rate is compounded and settled on reset dates.
• The fixed leg's value remains constant and is factored into the swap's total valuation.
• Present value computations depend on compounding or geometric averaging of overnight rates.
• Calculating present values requires building an interest rate curve.

How Does an Overnight Index Swap Work?

In an OIS, one party agrees to pay a fixed rate, while the other pays a variable rate based on the overnight index. The floating rate leg accrues interest daily, compounded over the term and paid at designated reset dates.

Financial institutions favor OIS contracts as they closely reflect interbank lending conditions and carry lower risk compared to traditional interest rate swaps.

Step-by-Step Guide to Calculating an OIS

1. Determine the effective overnight rate by multiplying the daily rate by the number of days in the swap period (e.g., a Friday start accounts for weekend days).
2. Divide this effective rate by 360, the industry-standard day count for OIS calculations.
3. Add one to the result to reflect growth.
4. Multiply by the principal amount to get the accrued value.
5. Repeat the daily calculation for the entire swap period, updating principal accordingly.
6. Calculate the fixed leg rate similarly, dividing by 360 and adding one.
7. Raise this rate to the power of the total days and multiply by the principal.
8. Subtract the floating leg total from the fixed leg total to find the net benefit or cost.

Why Use an Overnight Index Swap?

Financial firms use OIS contracts to hedge against sudden short-term interest rate fluctuations, helping stabilize borrowing costs. Traders also employ OIS to speculate on future interest rate movements.

Is an OIS a Derivative?

Yes, an Overnight Index Swap is a derivative instrument. It derives its value from underlying short-term interest rates without involving ownership of actual assets.

Conclusion

The Overnight Index Swap is a crucial financial instrument in 2024 for managing short-term interest rate risk efficiently. Widely used by banks, hedge funds, and market speculators, it offers a reliable mechanism to hedge or gain exposure to interest rate changes with minimized credit risk.

Discover the latest news and current events in Trading Strategies as of 23-05-2024. The article titled " Overnight Index Swap (OIS) Explained: 2025 Pricing & How to Calculate " provides you with the most relevant and reliable information in the Trading Strategies field. Each news piece is thoroughly analyzed to deliver valuable insights to our readers.

The information in " Overnight Index Swap (OIS) Explained: 2025 Pricing & How to Calculate " helps you make better-informed decisions within the Trading Strategies category. Our news articles are continuously updated and adhere to journalistic standards.