Overnight Indexed Swap

Swap is a derivative contract and an OTC(Over-the-counter) one. A derivative is a product that derives its value from the underlying Asset. Now, Interest Rate Swaps have cornered the market. Financial institutions resort to this product to hedge interest rate risk, to minimize any issue emanating from Asset Liability mismatch.

Let's delve into the dynamics of this complex product. There are primarily two counterparties, one investment bank in between to make the market or bring the two parties together. Need to remember these are not standardized contracts, won't find it in the exchanges, has to be tailor-made.

1. Notional Amount : This amount never gets exchanged during the course of the transaction, the only purpose is to calculate the interest component.
2. Tenure and Starting and the Finishing date.
3. Choosing the Index for the floating leg.

Mechanism of the Swap

Swap literally means exchange of payments. In this contract, two counterparties swap one Fixed rate payment for a Floating rate payment based on the Notional Amount. This is known as the "Fixed for Float" swap and is widely used to hedge interest rate risk.

If one party assumes that the interest rate in the prevailing economy is going down and wants to capture the upside then one would opt for the floating rate and if the counterparty feels otherwise they would opt for the Fixed payment obligation, in the end only the difference of payments would be exchanged.

Now, during the deal the index which would be used to decide the floating rate component is decided. LIBOR is primarily used until now. Sooner,SOFR(Secured Overnight Financing rate) would be replacing it. Once index is chosen then spread is also added to indicate the riskiness of the product. Need to remember that counterparty risk is always there.

Now, "Overnight Indexed Swap" essentially means that the index chosen for Floating rate is an index which gets compounded Overnight. In India 1 year and 5 year OIS are most liquid. Not only that OIS rates are also used for gauging the trajectory of the impending interest rate scenario.

MIBOR is primarily used for calculating the floating rate. Amongst the interest rate derivatives FRA(Forward Rate Agreement) is also another kind of derivative which gets some traction but that's beyond the scope of the discussion.