What is Overnight Index Swap?

About Overnight Index Swap (OIS):

• It is a derivative instrumentwhere returns under a fixed rate asset are swapped against a pre-determined published index of a daily overnight reference rate for an agreed period of time.
• Purpose: The primary purpose of an OIS is to manage interest rate risk, particularly the risk associated with fluctuations in the overnight lending rate.
• It is calculated each day.
• This interest rate is based on the average interest rate institutions with loans based on the overnight rate have paid for that day.

How does an OIS work?

• These are instruments that allow financial institutions to swap the interest rates they are paying without having to refinance or change the terms of their existing loan.
• When two financial institutions create an overnight index swap, one of the institutions is swapping an overnight (floating) interest rate and the other institution is swapping a fixed short-term interest rate.
• To get the swap rolling, both the firms would agree to continue servicing their loans, but at the end of a specified time period whoever ends up paying less interest will make up the difference to the other firm.