Overnight Index Swaps (OIS) are instruments that allow financial institutions to swap the interest rates they are paying/receiving without having to refinance or change the terms of the loans they have taken/given from/to other financial institutions. When two parties swaps a transaction one received fixed rate while other floating which is normally MIBOR. IS involves swapping of only the interest flows, the principal amount is notional, to be used just for calculation of interest rates. Tenor of the contract ranges from 1month to 10 year. In India maximum liquidity is in the contract for 1 year. Borrower of the contract pays a fixed rate of interest to the seller and the seller pays a floating rate to the buyer. One contract by default is for Rs 25 crores.
Let’s understand it with an example:
A Ltd. has raised 1000crores at fixed rate of 8%. A Ltd. thinks that rate may fall in near future but not to great extent. Now if A Ltd prefers to call back the capital and reissue again then cost of the same would set off the actual gains. Now If A ltd. wishes to enjoy lowering rates and avoid re-issuance hassles then they would sell an OIS contract (Always remember seller of an OIS receives Fixed whereas buyer receives floating MIBOR). Hence what happens in this case is A ltd. is paid fixed rate by the buyer of OIS which A Ltd. hypothetically transfers in to investors of their debentures and pays overnight rate in return to the buyer of the swap. Refer diagram below:
Let’s see how calculation works:
Let’s assume A Ltd. sells OIS and agrees to receive fixed rate of 7.8% for five days and will pay floating MIBOR for the same period with X Ltd. then cash flow will work this way:
For 5days as per fixed rate A is assumed to receive Rs.267123 and below is the calculation which A will have to pay to X Ltd as per the contract. i.e. Rs.263387. OIS settles at net amount. Hence in this case after five days Mr. A will receive (267123-263387) Rs.3750.
It is widely used by Banks, Financial Institution, PDs, corporate, etc. Volume in this market is growing at a slow pace but is expected to increase to a great extent.
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