ois what is it all about

8/3/2019 Ois What is It All About

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OIS what is it all about?

The Polish market of swaps indexed to the overnight rate (Eng. Overnight index swap,

abbreviated as OIS) is a very young market though a very prospective one too. Its beginning

was not easy. Some market participants did not believe at all in the possibility of the market

being created for the Polish currency. It suffices to mention that the first transactions werepreceded by ca. 4 years of meetings, debates and agreements to realize how bad the situation

was. It was mainly due to the absence of a reliable reference index. What made the matters

worse were system barriers which the bankers encountered in their banks and which prevented

concluding transactions right away. Most often internal regulations required totally separate

procedures and business guidelines which had to be created from scratch. No wonder,

however, the market was becoming increasingly skeptical. On the other hand, high volatility of

1-day money market rates and chronic absence of limits for deposit transactions made the topic

resurface. OIS transactions offer an opportunity for ideal hedging of cash positions in the

periods of the smallest volatility. They also allow to take positions more efficiently depending on

the expectations of the future money market curve (derivative limits weigh much less on creditrisk exposure than standard credit utilization). A long period of waiting for the product along with

the benefits it may bring, resulted in the banks high interest when the first OIS transactions

were concluded (March 2004). The fate of the market is not decided yet though its further

growth seems more likely than the probability of its collapse.

This article is aimed at bringing overnight index swaps (further referred to as OIS) closer to a

wider group of customers. It was written in response to the growing interest in this product

among individuals with no professional interest in the dealing room, and for everybody looking

for comprehensive, cumulative information on that topic. The text includes full description of the

product, basic ways of its pricing and information on the Polish OIS market.

Starting with the definition: OIS is a swap of fixed interest rate in exchange for a floating

interest rate where the floating rate is determined on the basis of the daily reference 1-day rate

(in Poland it is Polonia rate). It is a contract of swapping two money flows.

- Fixed leg which is an one-off payment, i.e. interest calculated acc. to the fixed, defined in

the contract, interest rate on a certain agreed nominal value.

- Floating leg which is a one-off payment, i.e. interest accrued daily, calculated based on the

ON rate on the agreed nominal amount of the contract.

(Interest) payments are swapped at the contract maturity by way of net settlement. In practice,

the settlement takes place on the first business day following the maturity date. This is dictated

by the fact that Polonia rate is an average interest rate calculated on one-day transactions

concluded on a given day, weighted by their nominal amounts.

Terms of standard OIS contracts match the terms of standard deposits in the inter-bank

money market (from one week to one year). The fashion of quoting the prices of these contracts

is the same as for deposits. In particular, the beginning and end of the OIS interest period are

the same as for a deposit with the same maturity date.

Further comparison to deposits shows that it is true that if it is possible to borrow cash with the

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same maturity and the same interest rate as in the case of a swap, and if the cash is re-invested

in the market each day at an interest rate equal to a given index, and if the amount of cash paid

at maturity is exactly the same as the return on the swap transaction then OISs are a perfect

hedge for such a financial instrument. From the economic point of view, receiving a fixed

interest rate in OIS is like lending money to someone while paying such a rate can be comparedto borrowing money. In dealers speak, buying OIS means paying a fixed interest rate and

receiving a floating rate. In the case of selling OIS its the other way round.

OIS swaps allow to change risk profile related to the change in interest rates of a given

portfolio without any cash involved and with a minimum utilization of credit limits. These features

are conducive to flexible interest rate risk management and allow to actively trade in OIS as a

financial instrument.

OIS enhance liquidity with respect to money market curves as well mitigating the system risk

referring to cash transactions. They also help enhance efficiency in the management ofshort-term liquidity. Reswapped term deposits are obtained based on the floating ON rate which

makes them independent of the fixed interest rate. The bank first pays fixed interest rate on the

deposit to receive it back through an OIS transaction while the interest is calculated according

to the floating ON rate (it is a big advantage in the case of positive sloped yield curves).

The key purposes of using OIS are: - Interest rate risk management OIS are derivative

instruments of the money market and as such are characterized by a much bigger liquidity than

the money market itself, especially for long tenors. OIS are usually quoted with smaller spreads

which enables more precise calculation of forward-forward rates to create more accurate

forward curves reflecting market expectations of interest rates going forward (in developedmarkets the beginnings of the curves are designed by means of 1M or 3M futures and require

interpolation; it can be avoided thanks to OIS rates).

- Carry trade OIS transactions make an excellent tool for the so-called carry trade on the

short end of the yield curve. If the dealer decides that the overnight forward curve is too flat they

can pay OIS (they pay a fixed rate by receiving a floating one). If, however, the trader believes

that this curve is too steep, they can sell OIS by receiving a high fixed rate and paying a floating

rate which (at least according to his expectations) drops every day.

- Swapping maturity terms through OIS this usage can most straightforwardly be presentedby means of an example where assets with a 3M maturity are swapped for a 1 week rate. To

achieve this, a 3M rate of a given asset would have to be reswapped for a 1 day interest rate by

way of buying a 3M OIS and next by selling a 1 week OIS a fixed 3M interest rate would have to

be reswapped for a fixed 1 week interest rate. This way, the 3M return rate on the asset offsets

the OIS 3M fixed rate (most often leaving some spread), similarly both 1-day floating rates

offset. Only 1 week fixed interest rate remains. In the same way, we can swap any maturity

terms up to 1 year, and even longer (there are markets with OIS curves of up to two years).

- Hedging the cost of funding, if the cost is a 1 day reference index purchase of OIS hedges

the Bank against the increase of 1 day deposit rates. This is a more accurate hedge than usingother term derivatives. This is mainly due to the fact that the other allow for the so-called

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squeezes or temporarily cheap short money to a very small extent. Squeeze is a situation

where the shortest term interest rates grow violently as there is less cash in the banking system

than apparently necessary given the must to keep the obligatory reserve on deposits at a

specific level. Temporarily cheap money occurs when the amount of cash in turnover is much

higher than required.

- Managing liquidity and swapping term liabilities Banks like to manage liquidity on the ON

value date given high flexibility of the strategy. With the growing yield curve, a big role is also

played by the economic aspect. In such circumstances, term deposits create unwanted costs

relative to short-term deposits. Of course the obtained funds can be allocated at the further end

of the curve and funding can be raised from ON, however such a strategy causes the so-called

blockage of credit lines and significantly increases the banks operational risk. OIS seem to be

an ideal solution to this problem. They enable sourcing funds for long terms and swapping them

for a 1 day index without the necessary utilization of credit, liquidity limits, etc.

Apart from the basic purposes of using OIS, the following risks related to OIS turnover should

also be taken into account: - Settlement risk much smaller than in the case of classic

deposits. It merely includes the risk of losing the difference between interest cash flows arising

from the fixed and floating leg of the swap , accrued over its life. The risk is usually estimated in

the tenths of the nominals percentage (for deposits it is 100%). -

Market risk OIS curve on developed markets is usually 3-10 basis points below the cash

curve. This base reflects the fact that OIS are derivatives which only involve interest flows

without capital movement (lower risk premium) and do not require funding. For longer terms, the

effect of capitalizations should also be taken into account. The base widens in the periods of the

less liquid market.

- Liquidity risk in the developed markets, the risk practically does not exist. OIS markets

usually significantly outperform the corresponding deposit markets in terms of the turnover

scale.

In Poland this risk should now be treated as one of the basic risks which can lead the OIS

market to extinction in an extreme case. As it was mentioned in the introduction, the Polish OIS

market tried to kick off a few years ago but the entire undertaking ended with a fiasco for the

very reason of most markets unreadiness to deal. Also today, the whole market is created by a

few banks and if this situation does not change the history may be repeated. Other banks arewilling to join the process of creating this market and if the system problems do not stifle the

willingness perhaps pretty soon OIS will be actively quoted at least by other participants who

make up the WIBOR index.

There is something to fight for at least given the prospects offered by the market. In the

developed markets not only simple OIS rates are quoted but also their structures like

forward-forward. Over a few years, it could also be the target of the banks operating in

Poland. Not only would it make the Polish market more liquid but would also prepare

local players to enter the EURO zone where such transactions are a common feature.

The basic valuation of the OIS settlement amount can be calculated by means of two simple

formulas: OIS fixed interest payments are calculated according to the simple interest formula:O = (NP*R*D)/100*DB

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Where:

O the total of interest due

NP base amountD OIS term (in days)

R Agreed fixed interest rate (in %)

DB base number of days

For the Polish market, the base number of days in OIS transactions is 365 days.

OIS floating interest payments are calculated according to the daily capitalization formula: NP*{

(1+O1*D1/36500)*(1+O2*D2/36500)*.*(1+On*Dn/36500)-1}

where:

NP base amountOn OIS index for the n-th dy of the swap

Dn number of days for the n term

The settlement amount is the absolute value of the difference between the two values above.

To summarize, the key advantages of OIS are: - Easy use,

- The fact it is the only OBS alternative for cash transactions,

- Minimum credit risk,

- Higher liquidity and narrower spreads relative to deposits,

- No necessity for excessive pumping of the B/S,

- System risk mitigation.

To conclude, it is also worth mentioning that OIS dealings are usually based on the InternationalSwaps and Derivatives Association agreement. The ISDA 1991 definition along with

subsequent amendments defines the reference of the floating interest rate, used for all the key

currencies, and is updated once new currencies are added.

In Poland it is supplemented by the recommendation of Stowarzyszenie Dealerw Bankowych

ACI POLSKA on OIS dealings issued in 2004.

Author: Bartomiej Maocha

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ois what is it all about

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