Overnight indexed swap
Encyclopedia
An overnight indexed swap (OIS) is an interest rate swap
where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate which is also called Overnight Rate) over every day of the payment period. The index is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR).
In the United States, OIS rates are calculated by reference to daily federal funds rate
.
OIS rates
(or, in particular, the difference or "spread" between LIBOR and OIS rates) are an important measure of risk and liquidity in the money market, considered by many, including former US Federal Reserve chairman Alan Greenspan
, to be a strong indicator for the relative stress in the money market
s. A higher spread (high Libor) is typically interpreted as indication of a decreased willingness to lend by major bank
s, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes.
The LIBOR-OIS spread has historically hovered around 10 basis point
s. However, in the midst of the financial crisis of 2007–2010, the spread spiked to an all-time high of 364 basis points in October 2008, indicating a severe credit crunch
. Since that time the spread has declined erratically but substantially, dropping below 100 basis points in mid-January 2009 and returning to 10-15 basis points by September 2009.
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate which is also called Overnight Rate) over every day of the payment period. The index is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR).
In the United States, OIS rates are calculated by reference to daily federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
.
OIS rates
LIBOR-OIS spread
The LIBOR–OIS is the difference between LIBOR and the overnight indexed swap rates. The spread between the two rates is considered to be a measure of health of the banking system.-Risk barometer:...
(or, in particular, the difference or "spread" between LIBOR and OIS rates) are an important measure of risk and liquidity in the money market, considered by many, including former US Federal Reserve chairman Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
, to be a strong indicator for the relative stress in the money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
s. A higher spread (high Libor) is typically interpreted as indication of a decreased willingness to lend by major bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes.
The LIBOR-OIS spread has historically hovered around 10 basis point
Basis point
A basis point is a unit equal to 1/100 of a percentage point or one part per ten thousand...
s. However, in the midst of the financial crisis of 2007–2010, the spread spiked to an all-time high of 364 basis points in October 2008, indicating a severe credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
. Since that time the spread has declined erratically but substantially, dropping below 100 basis points in mid-January 2009 and returning to 10-15 basis points by September 2009.