Ois What is It All About

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  • 8/3/2019 Ois What is It All About


    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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    OIS what is it all about?

    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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    OIS what is it all about?

    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 pr