Overnight Index Swap

About Overnight Index Swap: 

• It is a derivative instrument where 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.
• An overnight index swap rate 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.

Q1: What are Derivatives?

Derivatives refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. These contracts can be used to trade any number of assets and carry their own risks.

Source: Monetary policy review: FPI investment limit in OIS market under review