An Overnight Indexed Swap (OIS) is a derivative contract where two parties exchange interest payments: one leg pays a fixed rate, while the other pays a floating rate based on a compounded overnight interest rate index. It serves as a financial instrument for hedging or speculating on short-term interest rate movements with minimal credit risk.
Mechanism
The operational mechanism of an OIS involves periodic settlement based on the difference between a predetermined fixed rate and the average of an overnight reference rate, such as SOFR or ESTR, compounded daily over a specific term. Cash flows are exchanged at the end of the swap period, with the floating leg reflecting market expectations for future short-term rates, effectively isolating interest rate risk from credit risk due to the nature of the underlying overnight rate.
Methodology
OIS contracts are critical tools for central banks and financial institutions to manage short-term liquidity, hedge funding costs, and express views on monetary policy expectations. Their methodology provides a highly transparent and low-credit-risk benchmark for assessing market-implied future policy rates, making them indispensable for pricing other short-term derivatives and for informing sophisticated hedging strategies against fluctuations in overnight funding. This instrument’s principles of rate referencing and risk isolation could conceptually extend to interest rate derivatives in a maturing regulated crypto lending market.
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