Introduction

In this chapter, we will delve into the world of Overnight Indexed Swaps (OIS) and explore how they differ from LIBOR (London Interbank Offered Rate) swap rates. OIS has gained significant prominence in recent years, particularly in the wake of the financial crisis when concerns about the integrity of LIBOR emerged. Understanding OIS is crucial for comprehending contemporary interest rate markets and risk management strategies.

Overnight Indexed Swaps (OIS)

An Overnight Indexed Swap (OIS) is a type of interest rate derivative that allows parties to exchange fixed-rate interest payments for floating-rate interest payments indexed to an overnight reference rate. Unlike LIBOR, which relies on interbank lending, OIS references a more secure rate, typically the overnight rate set by central banks, such as the Federal Funds Rate in the United States or the Euro Overnight Index Average (EONIA) in the Eurozone.

Distinguishing OIS Rates from LIBOR Swap Rates

1) Underlying Rate

• OIS: OIS rates are based on the overnight rate set by central banks. These rates are considered to be almost risk-free as they reflect the cost of borrowing for banks with very short maturities.
• LIBOR Swap Rates: LIBOR swap rates are based on the LIBOR benchmark, which represents the rate at which banks are willing to lend to each other. However, LIBOR rates have faced credibility issues, especially during times of financial distress.

2) Credit Risk

• OIS: OIS contracts are less exposed to credit risk since they rely on central bank rates, which are typically considered risk-free.
• LIBOR Swap Rates: LIBOR-based contracts may be exposed to credit risk because they are based on the rates at which banks lend to each other, and creditworthiness can vary.

3) Tenor

• OIS: OIS contracts typically have shorter tenors, often ranging from overnight to a few months.
• LIBOR Swap Rates: LIBOR-based contracts can have longer tenors, extending to several years.

4) Market Usage

• OIS: OIS contracts are commonly used for hedging and speculative purposes, especially when market participants want to minimize credit risk exposure.
• LIBOR Swap Rates: LIBOR-based contracts are used for a wide range of purposes, including hedging, borrowing, and investment.