Acquired overnight index swap: Meaning, Criticisms & Real-World Uses

What Is an Overnight Index Swap (OIS)?

An Overnight Index Swap (OIS) is a type of financial derivative, specifically an interest rate swap, in which two parties agree to exchange a fixed interest rate payment for a floating interest rate payment linked to an overnight index rate. This financial contract, belonging to the broader category of financial derivatives, is primarily used by financial institutions to manage interest rate risk and gain exposure to short-term interest rate movements³⁷. Unlike traditional interest rate swaps, the floating leg of an OIS is based on a daily compounded overnight reference rate, which reflects the rate at which banks lend and borrow money on an unsecured or secured overnight basis. This daily resetting mechanism is a key characteristic of an Overnight Index Swap, and the fixed rate agreed upon in the OIS is often considered a reliable indicator of market expectations for future overnight rates³⁶.

History and Origin

The concept of interest rate swaps gained traction in the 1980s, but the Overnight Index Swap market specifically emerged in the 1990s as a response to the need for more precise management of short-term interest rate risk. A significant development for the OIS market in Canada, for instance, was its introduction in 1999, which provided participants with a new instrument to hedge or speculate on overnight market expectations and enhanced the informational efficiency of the market³⁵.

The importance and adoption of OIS rapidly accelerated after the 2008 global financial crisis. Prior to the crisis, many derivatives were valued using interest rates derived from interbank lending benchmarks like LIBOR (London Interbank Offered Rate), which were perceived as nearly risk-free. However, the crisis exposed weaknesses and a widening spread between LIBOR and other overnight rates, leading to a loss of trust in LIBOR as a sole discount rate for collateralized transactions³³, ³⁴. Consequently, market participants shifted towards using OIS rates for discounted cash flow valuations, particularly for collateralized derivatives, because OIS rates are closely tied to actual overnight lending and are considered to carry less counterparty risk due to their short-term nature and central clearing³⁰, ³¹, ³².

Key Takeaways

An Overnight Index Swap (OIS) is a financial derivative used to exchange a fixed rate for a floating rate based on a compounded overnight index.
OIS contracts are crucial for managing short-term interest rate exposures and are widely used by financial institutions.
The OIS rate serves as a key indicator of market expectations for future central bank monetary policy and the "risk-free" rate.
Post-2008 financial crisis, OIS rates became the standard for discounting collateralized derivative valuations due to their lower credit risk profile.
OIS contracts facilitate hedging against fluctuations in overnight lending rates and can be used for speculation on rate movements.

Formula and Calculation

The calculation of the floating leg of an Overnight Index Swap involves compounding the daily overnight rates over a specified period. The fixed rate is then determined such that the present value of the fixed payments equals the present value of the expected floating payments at the initiation of the swap.

The compounded floating rate ($F_i$) for a given accrual period ($[T_{i-1}, T_i]$) is typically calculated as the geometric average of the daily overnight rates ($r_j$) over that period:

F_i = \left( \prod_{j=1}^{N} (1 + r_j \cdot \tau_j) \right)^{\frac{1}{\sum \tau_j}} - 1

Where:

$N$ = Number of business days in the accrual period.
$r_j$ = The overnight index rate on day $j$.
$\tau_j$ = Day count fraction for day $j$ (e.g., $1/360$ for Actual/360 convention).

The payment for the floating leg at the end of the period would be $F_i \cdot \text{Day Count Fraction} \cdot \text{Notional Principal}$. The fixed interest rate on the other leg is constant throughout the life of the swap, and the net payment exchanged between parties is the difference between the fixed and floating payments based on the notional principal ²⁹.

Interpreting the Overnight Index Swap

The Overnight Index Swap rate is widely regarded as a strong indicator of market expectations for the future path of a central bank's policy rate, often considered a proxy for the risk-free rate in a given currency²⁷, ²⁸. When the OIS curve, which reflects OIS rates across different maturities, is upward sloping, it generally signals that the market anticipates future interest rate increases by the central bank. Conversely, a downward-sloping OIS curve suggests expectations of future rate cuts²⁶.

Financial professionals and investors use the OIS curve to gauge market sentiment regarding future monetary policy decisions. Its purity as an indicator stems from the fact that, unlike other yield curve instruments, the OIS curve primarily reflects interest rate expectations with minimal incorporation of credit risk, especially when contracts are centrally cleared²⁵. This makes it a critical tool for analyzing the market's outlook on short-term rates and for making informed assessments about central bank intentions.

Hypothetical Example

Consider two financial institutions, Bank A and Bank B, entering into a 6-month Overnight Index Swap with a notional principal of $100 million.

Bank A agrees to pay a fixed interest rate of 2.50% annually, paid semi-annually.
Bank B agrees to pay a floating interest rate based on the daily compounded Secured Overnight Financing Rate (SOFR) over the 6-month period, also paid semi-annually.

At the end of the first three months, the daily SOFR rates are compounded. Suppose the compounded SOFR for this period averages out to 2.30%.

Calculation for the first 3 months:

Bank A (Fixed Payment): $100,000,000 \times 2.50% \times (3/12) = $625,000$
Bank B (Floating Payment): $100,000,000 \times 2.30% \times (3/12) = $575,000$

Since Bank A's fixed payment ($625,000) is greater than Bank B's floating payment ($575,000), Bank A will pay Bank B the net difference: $625,000 - $575,000 = $50,000$.

This process repeats for the second three-month period. This example illustrates how the Overnight Index Swap allows parties to exchange interest rate exposures, effectively converting a floating rate exposure to a fixed rate one, or vice-versa.

Practical Applications

Overnight Index Swaps serve multiple critical functions in financial markets and for various participants:

Interest Rate Risk Management: Financial institutions, such as banks and pension funds, use OIS to manage exposure to short-term interest rate fluctuations. By entering into an OIS, they can transform floating interest rate liabilities into fixed interest rate payments, or vice-versa, providing stability to their funding costs and portfolio returns²², ²³, ²⁴.
Market Expectations and Benchmarking: The OIS rate is widely followed as an indicator of market expectations for central banks' future policy rates. This makes the OIS curve a crucial benchmark for pricing other financial instruments and assessing overall market sentiment regarding short-term rates¹⁹, ²⁰, ²¹.
Collateralized Derivatives Valuation: A significant application of OIS is in the valuation of cash-collateralized derivative contracts, a practice known as OIS discounting methodology. This became standard after the 2008 financial crisis, as OIS rates were deemed a more appropriate and less credit-risky benchmark for discounting cash flows of collateralized trades compared to previous methods¹⁷, ¹⁸.
Liquidity Management and Arbitrage: Banks and other financial institutions utilize OIS for short-term funding and liquidity management. They also engage in arbitrage strategies, capitalizing on discrepancies between OIS rates and other market rates to generate profits¹⁶.
Replacing LIBOR: With the discontinuation of LIBOR, many financial contracts that previously referenced LIBOR have transitioned to alternative overnight reference rates such as SOFR (Secured Overnight Financing Rate) for USD, SONIA for sterling, or ESTR for Euro. OIS contracts referencing these new rates are instrumental in facilitating this transition and managing associated risks [2, 12, 26, SOFR transition].

Limitations and Criticisms

While Overnight Index Swaps are highly valued for their role in interest rate risk management and market transparency, they do have certain limitations and potential drawbacks.

One primary consideration is counterparty risk. Although OIS contracts, especially those cleared through central counterparties, are generally considered to have lower credit risk than traditional derivatives due to the short-term nature of the underlying rate and netting mechanisms, the risk of a counterparty defaulting on its obligations still exists¹⁴, ¹⁵. This risk, while mitigated by daily collateral calls and central clearing, is a factor that market participants must continually monitor.

Another limitation is the sensitivity of OIS contracts to unexpected changes in the underlying overnight rates. While OIS can hedge against anticipated rate movements, sudden and unforeseen fluctuations in central bank policy or market liquidity can lead to market risk, potentially resulting in losses for the party paying the floating interest rate ¹³.

Furthermore, while OIS rates are excellent indicators of risk-free rates and central bank expectations, they may not fully capture the broader credit risk premiums present in the financial system that are reflected in other interbank lending rates or corporate funding costs. The LIBOR–OIS spread, for example, was historically viewed as a barometer of liquidity and credit stress in the banking system, illustrating that OIS rates alone do not provide a complete picture of financial health.

Overnight Index Swap vs. Interest Rate Swap

An Overnight Index Swap (OIS) is a specific type of interest rate swap, and while they share fundamental characteristics, their key differentiating factor lies in the reference rate used for the floating leg.

Feature	Overnight Index Swap (OIS)	Traditional Interest Rate Swap (IRS)
Floating Rate Basis	Daily compounded overnight rate (e.g., SOFR, Fed Funds Rate)	¹² Term interbank rate (e.g., historical LIBOR, Euribor)
Credit Risk	Generally considered lower, closer to a risk-free rate, due to the overnight nature and often secured underlying	¹¹ Higher, as term interbank rates historically embed a credit risk component of the lending banks
Primary Use	Managing short-term interest rate risk, discounting collateralized derivatives, signaling central bank expectations	⁹, ¹⁰ Hedging against longer-term interest rate fluctuations, transforming fixed-to-floating or vice-versa
Compounding	Floating leg compounded daily over the accrual period	Floating leg typically resets periodically (e.g., quarterly, semi-annually) without daily compounding

The confusion between the two often arises because both involve the exchange of fixed interest rate and floating interest rate payments on a notional principal. However, the underlying reference rate and its implications for credit risk and valuation are what distinguish an OIS from a broader interest rate swap. The term "Acquired Overnight Index Swap" is not a distinct financial instrument but simply refers to an OIS that has been entered into or "acquired" by a party.

FAQs

What is the main purpose of an Overnight Index Swap?

The main purpose of an Overnight Index Swap is to manage short-term interest rate risk and to provide market participants with a pure indicator of future overnight interest rate expectations, closely tied to central banks' policy rates.
⁵, ⁶

How does an OIS reflect market expectations for central bank rates?

The fixed rate component of an OIS is determined by market expectations of the average future path of the overnight index over the life of the swap. If the fixed OIS rate for a given maturity is higher than the current overnight rate, it implies the market expects the central bank to raise rates in the future, and vice-versa.
³, ⁴

Is an Overnight Index Swap a type of derivative?

Yes, an Overnight Index Swap is a type of financial derivative, specifically an interest rate swap. Derivatives are financial contracts whose value is derived from an underlying asset, rate, or index [8, IMF definition of financial derivatives].

How is the floating rate calculated in an OIS?

The floating rate in an OIS is typically calculated by geometrically compounding the daily readings of a specified overnight index rate (such as the Federal funds rate or SOFR) over the relevant accrual period.

What is OIS discounting?

OIS discounting methodology is the practice of valuing cash-collateralized derivative contracts using OIS rates as the discount rates. This method gained prominence after the 2008 financial crisis as it more accurately reflects the funding costs and returns on collateral posted against such derivatives, thereby reducing the embedded credit risk in valuations.¹, ²