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

What Is Active Overnight Index Swap?

An Active Overnight Index Swap (OIS) is a type of derivatives contract within the realm of fixed income instruments, where two parties agree to exchange interest payments. Specifically, one party pays a fixed rate of interest on a predetermined notional principal, while the other party pays a floating rate of interest that is compounded daily from an overnight benchmark interest rate. The "active" aspect often refers to the high liquidity and frequent trading of these instruments, allowing for dynamic management of short-term interest rate exposures.

This financial instrument is commonly used by financial institutions, corporations, and investors to manage interest rate risk and gain exposure to overnight rates without directly lending or borrowing funds for extended periods. An Active Overnight Index Swap provides a precise way to express views on future monetary policy and short-term market conditions.

History and Origin

The concept of Overnight Index Swaps emerged as financial markets sought more robust and transparent benchmarks for short-term interest rates. While traditional interest rate swaps linked to interbank lending rates like LIBOR had long existed, the global financial crisis of 2008 highlighted vulnerabilities in such benchmarks, particularly their reliance on bank submissions rather than actual transactions. LIBOR's eventual phaseout led to a push for new, transaction-based rates.

The Canadian Overnight Repo Rate Average (CORRA)-based OIS market, for instance, was introduced in 1999, improving the informational efficiency of the overnight market.¹³ In the United States, the Alternative Reference Rates Committee (ARRC), convened in 2014 by the Federal Reserve Board and the Federal Reserve Bank of New York, identified the Secured Overnight Financing Rate (SOFR) as the preferred alternative to U.S. dollar LIBOR.¹² SOFR is based on overnight transactions in the U.S. dollar Treasury repo market, making it a robust, transaction-based rate.¹¹ The adoption of SOFR and other risk-free rates (RFRs) globally has further solidified the importance and active trading of Overnight Index Swaps, as they derive their floating leg from these new, resilient benchmarks.

Key Takeaways

An Active Overnight Index Swap involves the exchange of a fixed rate for a floating rate based on a daily compounded overnight index.
These swaps are crucial for managing short-term interest rate risk and expressing views on future monetary policy.
The floating leg of an OIS is calculated by compounding the daily overnight rates over the swap's term.
OIS rates are generally considered to reflect a very low level of credit risk, making them a purer indicator of market expectations for risk-free rates.
The transition from LIBOR to alternative rates like SOFR has significantly boosted the relevance and trading volume of Active Overnight Index Swaps.

Formula and Calculation

The calculation for an Active Overnight Index Swap involves determining the total interest accrued on both the fixed and floating legs over the contract period. The notional principal is used solely for calculating interest payments and is not exchanged.

The interest for the floating leg is calculated by compounding the daily overnight rates. Let (N) be the notional principal, (R_{o,i}) be the overnight reference rate on day (i), and (D) be the number of days in the interest period. The floating interest rate for the period is:

R_{floating} = \left( \prod_{i=1}^{D} \left(1 + \frac{R_{o,i}}{360}\right) - 1 \right) \times \frac{360}{D}

The total floating payment for the period is then (N \times R_{floating} \times \frac{D}{360}). Note that the 360-day convention is common in these calculations.

For the fixed leg, let (R_{fixed}) be the agreed-upon fixed rate. The total fixed payment for the period is:

Fixed Payment = N \times R_{fixed} \times \frac{D}{360}

On the settlement date, the difference between the fixed payment and the floating payment is exchanged between the two parties, rather than the notional principal itself.

Interpreting the Active Overnight Index Swap

The rate of an Active Overnight Index Swap (OIS) reflects the market's expectation of the future path of the underlying overnight interest rate, such as the Federal Funds Rate in the U.S. or SOFR. Because OIS rates are considered to carry minimal credit risk, they are often viewed as a reliable indicator of "risk-free" interest rates.

When market participants anticipate that central banks will raise their policy rates, the longer-term OIS rates tend to be higher than shorter-term rates, indicating expectations of future rate hikes. Conversely, if the market expects rate cuts, longer-term OIS rates may be lower. The shape of the OIS yield curve provides insights into market sentiment regarding future monetary policy actions and overall liquidity conditions in the money markets.

Hypothetical Example

Consider two financial institutions, Bank A and Bank B, that want to manage their interest rate risk using an Active Overnight Index Swap with a 3-month term and a notional principal of $100 million. Bank A has a liability tied to the average daily SOFR and wants to convert it to a fixed rate, while Bank B wishes to do the opposite.

They agree to an OIS where Bank A pays Bank B a fixed rate of 5.00% per annum, and Bank B pays Bank A a floating rate based on the daily compounded SOFR.

Over the 90-day period:

The fixed payment for Bank A would be: $100,000,000 \times 0.0500 \times (90/360) = $1,250,000.
Suppose the daily compounded SOFR over the 90 days results in an effective floating rate of 4.85% per annum.
The floating payment for Bank B would be: $100,000,000 \times 0.0485 \times (90/360) = $1,212,500.

On the settlement date, Bank A owes $1,250,000 and Bank B owes $1,212,500. The net settlement would be Bank A paying Bank B the difference of $37,500 ($1,250,000 - $1,212,500). This allows Bank A to effectively pay a fixed rate, thereby hedging against a potential rise in the floating rate.

Practical Applications

Active Overnight Index Swaps are widely used in various segments of the financial markets:

Risk Management: Financial institutions use OIS to manage exposure to short-term interest rate fluctuations. For example, banks can convert floating rate liabilities into fixed rate cash flows to gain stability in interest payments.¹⁰
Liquidity Management: OIS helps institutions manage their funding and liquidity needs by providing an efficient tool to raise funds or invest surpluses at rates closely tied to central bank policy.⁸, ⁹
Monetary Policy Signal: The OIS market serves as a key barometer for market expectations regarding central banks' future policy rate decisions. Analysts frequently monitor OIS rates to gauge market sentiment on the trajectory of short-term interest rates.⁷
Arbitrage and Speculation: Traders and hedge funds utilize Active Overnight Index Swaps to capitalize on anticipated movements in short-term rates or to exploit price discrepancies between related financial instruments.
Central Bank Operations: While not direct participants in the OIS market, central banks indirectly influence it through their control over short-term interest rates, which are often used as the floating rate in OIS contracts. The Federal Reserve Bank of New York, for instance, engages in central bank liquidity swap operations to improve liquidity conditions in global money markets, which can impact the underlying rates referenced by OIS.⁶

Limitations and Criticisms

Despite their advantages, Active Overnight Index Swaps are subject to certain limitations and risks:

Market Risk: While generally considered less susceptible to credit risk than other swaps, OIS contracts are sensitive to unexpected changes in overnight rates. Unforeseen fluctuations in these rates can lead to potential losses for the party obligated to pay the floating rate.⁵
Counterparty Risk: Although often mitigated by daily margining and collateralization, particularly in centrally cleared transactions, the risk of a counterparty defaulting on its obligations remains.⁴ This is a general concern for all over-the-counter (OTC) derivatives.
Liquidity Risk: In periods of extreme market stress, liquidity in the OIS market, while typically high, can diminish, making it difficult to unwind positions without significant price concessions.³
Operational Risk: This encompasses potential issues related to the execution and management of OIS contracts, including errors in calculation, settlement, or collateral management.²
Basis Risk: While OIS generally reflect a pure view of the risk-free rate, differences can arise between the OIS rate and other funding rates for various market participants, leading to basis risk.

Active Overnight Index Swap vs. Interest Rate Swap

The Active Overnight Index Swap (OIS) is a specific type of interest rate swap, but a crucial distinction lies in the underlying reference rate for the floating leg. A standard interest rate swap often references a term interbank rate, such as LIBOR (historically) or a term version of a new benchmark interest rate like Term SOFR. These term rates reflect not only the pure interest rate but also an element of credit risk associated with unsecured interbank lending over that specific term.

In contrast, an Active Overnight Index Swap's floating leg is explicitly tied to a daily compounded overnight rate, such as the Federal Funds Rate or SOFR. These overnight rates are typically considered near risk-free, especially SOFR, which is collateralized by U.S. Treasury securities. Consequently, the fixed rate determined in an OIS is a purer reflection of the market's expectation of future central bank policy rates and is less influenced by bank credit risk premiums. This makes OIS a more precise tool for isolating and managing exposures to monetary policy expectations rather than general credit conditions in the banking sector.

FAQs

What is the primary purpose of an Active Overnight Index Swap?

The primary purpose of an Active Overnight Index Swap is to manage interest rate risk associated with short-term borrowing or lending. It allows parties to exchange a fixed interest rate for a floating rate tied to an overnight benchmark, providing a hedge against adverse movements in short-term rates.

How is the floating rate calculated in an OIS?

The floating rate in an OIS is calculated by compounding the daily actual overnight rates (such as SOFR or the Federal Funds Rate) over the specified period of the swap. This compounding reflects the true cost of borrowing or lending on an overnight, rolling basis.

Why is an OIS considered less risky in terms of credit than other swaps?

An OIS is generally considered to have lower credit risk because its floating leg is based on an overnight rate that typically reflects secured or very short-term unsecured lending between banks, which inherently carries less default risk. Additionally, many OIS are centrally cleared and subject to daily margining, further reducing counterparty risk.¹

What is the relationship between OIS rates and central bank policy?

OIS rates are highly sensitive to expectations about central banks' monetary policy decisions. Because the floating leg is tied to the central bank's policy rate (or a rate closely influenced by it), the fixed rate on an OIS reflects the market's collective forecast for the average level of that policy rate over the swap's term.

Is the notional principal exchanged in an Active Overnight Index Swap?

No, the notional principal in an Active Overnight Index Swap is only used to calculate the interest payments. The principal amount itself is never exchanged between the parties involved in the swap.