What it means
An overnight index swap is best understood as a bet on the average level of the central bank's policy rate over a stated period. One side locks in a fixed rate today, the other pays whatever the overnight rate actually turns out to average, and the two are netted at maturity.
Because the exchange is limited to the interest difference on a notional amount, the credit exposure is tiny relative to the size of the position. That small credit exposure is exactly why the OIS curve became so important.
Interest rates quoted on unsecured bank lending embed the risk that the borrowing bank fails, whereas an OIS rate embeds almost none, so the gap between the two became the market's standard gauge of banking stress. During periods of calm that spread is narrow, and it widens sharply when banks stop trusting each other.
Since the retirement of the old interbank benchmarks, the rates underlying these swaps have moved to the centre of the financial system. Overnight benchmarks such as the secured overnight financing rate in the United States and the sterling overnight index average in the United Kingdom now anchor loan pricing, derivative valuation and discounting.
Compounding those daily rates in arrears is how a floating rate for a three-month or six-month period is now constructed. Corporate treasurers use these swaps in two main ways.
The first is hedging, where a business with floating-rate borrowings pays fixed on a swap to convert an uncertain interest bill into a known one. The second is positioning, where a treasurer or fund manager takes a view that the central bank will cut or raise rates faster than the market has priced in.
The practical nuance is timing. The floating leg is not known until the period ends, since it is the compounded average of every overnight fix along the way, so settlement usually happens a day or two after maturity and forecasting the exact cash flow in advance is impossible.
In practice
Real-world examples.
Example
A property company with $80,000,000 of floating-rate debt expects rate rises and pays fixed on a two-year overnight index swap. Its interest bill is now predictable, which lets it commit to a development programme without needing to hold a large interest contingency.
Example
A bank's treasury desk watches the spread between three-month unsecured bank funding and the equivalent OIS rate widen from 15 basis points to 70. It reads this as a funding stress signal and lengthens the maturity of its own borrowing before conditions tighten further.
Example
A macro fund believes the central bank will cut rates sooner than the market expects. It receives fixed on a one-year overnight index swap, so that if the overnight rate averages below the fixed rate, the fund collects the difference without ever lending or borrowing the notional amount.
Think of it
“OIS is Overnight Index Swap-used to track interest rate expectations.
Formula
Calculation
Fixed Leg = Notional x Fixed Rate x Days / 360
Floating Leg = Notional x Compounded Overnight Rate x Days / 360
Net Settlement = Floating Leg - Fixed Leg
A treasurer enters a three-month overnight index swap on a notional of $50,000,000, paying a fixed rate of 4.00% and receiving the compounded overnight rate. The period runs for 90 days on a 360-day convention, so the day-count fraction is 90 / 360 = 0.25.
Fixed Leg = $50,000,000 x 4.00% x 0.25 = $500,000
The central bank raises rates during the quarter and the overnight rate compounds to an average of 4.25%.
Floating Leg = $50,000,000 x 4.25% x 0.25 = $531,250
Net Settlement = $531,250 - $500,000 = $31,250 received by the fixed-rate payer
The treasurer's floating-rate borrowings cost $31,250 more than budgeted over the quarter, and the swap pays exactly that amount back, leaving the effective cost at the fixed 4.00%.Case study
Seen in the real world.
Marlow Freight Group is a fictional logistics operator invented to illustrate how these swaps are used. It carried $120,000,000 of floating-rate debt priced at the overnight benchmark plus 175 basis points, and its board grew uncomfortable when a 1% move in rates translated into $1,200,000 of unbudgeted interest.
Rather than refinance into fixed-rate debt and pay an early repayment charge, the treasurer executed a two-year overnight index swap on $90,000,000 of the balance, paying a fixed rate of 3.80% and receiving the compounded overnight rate. That fixed three quarters of the exposure while leaving $30,000,000 floating so the group would still benefit if rates fell.
Rates rose over the following year and the swap paid Marlow the difference, holding the effective cost on the hedged portion at 3.80% plus the credit margin. In this illustrative example the swap did not make the company money in any meaningful sense; it made the interest line predictable enough to plan around, which was the point.
Watch out
Common mistakes.
- Thinking the notional amount is at risk. Principal is never exchanged, so the exposure is limited to the interest difference plus the counterparty's ability to pay it.
- Treating an OIS rate as a forecast. It reflects the market's current pricing of average overnight rates, which is a probability-weighted view rather than a prediction anyone is committing to.
- Assuming the floating leg is known in advance. It is compounded in arrears from daily fixings, so the final amount only becomes certain at the end of the period.
Questions
People also ask.
Why is the OIS rate treated as risk-free?
Because overnight lending exposes a lender to default risk for only one day at a time, so the accumulated credit risk embedded in the rate is close to negligible.
What does the spread over OIS tell me?
It isolates credit and liquidity risk, so a widening spread between term bank funding and the equivalent OIS rate is a well-established early warning of stress in the banking system.
Is this only for banks and large corporates?
In practice yes, since these are over-the-counter derivatives with documentation and collateral requirements, but the resulting rates feed into loan pricing that affects businesses of every size.
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