Overnight Index Swap

What Is an Overnight Index Swap?

An index swap alludes to a hedging contract in which a party exchanges a foreordained cash flow with a counter-party on a predefined date. A debt, equity, or other price index is utilized as the agreed exchange for one side of this swap.

An overnight index swap applies an overnight rate index like the federal funds or London Interbank Offered Rate (LIBOR) rates. Index swaps are specific gatherings of conventional fixed-rate swaps, with terms that can be set from 90 days to over a year.

How Does an Overnight Index Swap Work?

The overnight index swap signifies an interest rate swap including the overnight rate being exchanged for a fixed interest rate. An overnight index swap utilizes an overnight rate index, for example, the federal funds rate as the underlying rate for the floating leg, while the fixed leg would be set at a rate agreed on by the two players. The interest of the overnight rate portion of the swap is accumulated and paid at reset dates, with the fixed leg being represented in the swap's value to each party.

The floating leg's present value not set in stone by one or the other compounding of the overnight rate or by taking the geometric average of the rate over a given period.

Overnight index swaps are well known among financial institutions in light of the fact that the overnight index is viewed as a decent indicator of the interbank credit markets and safer than traditional interest rate spreads.

The most effective method to Calculate an Overnight Index Swap

Eight steps are applied in computing a bank's dollar benefit from utilizing an overnight index swap.

The initial step duplicates the overnight rate for the period in which the swap applies. On the off chance that the swap starts on a Friday, the swap's period is three days since transactions don't settle on ends of the week. On the off chance that the swap starts on another business day, the swap's period is one day. For instance, in the event that the overnight rate is 0.005% and the swap is placed on a Friday, the effective rate would be 0.015% (0.005% x 3 days), in any case, it's 0.005%.
Step two of the calculation isolates the effective overnight rate by 360. Industry practice directs that overnight swap calculations utilize 360 days for a year rather than 365. Utilizing the above rate, the calculation in step two is: 0.005%/360 = 1.3889 x 10^^-5^.
For step three, essentially add one to this outcome: 1.3889 x 10^-5 + 1 = 1.000013889.
In step four, duplicate the new rate by the total principal of the loan. For instance, in the event that the overnight loan has a principal of $1 million, the subsequent calculation is: 1.000013889x $1,000,000 = $1,000,013.89.
Step five applies the above calculations to every day of the loan, with the principal refreshed consistently. This is finished for multi-day loans in case the rate differs.
Steps six and seven are like two and three. The rate that overnight index swaps utilize must be partitioned by 360 and added to 1. For instance, on the off chance that this rate is 0.0053% the outcome is: 0.0053%/360 + 1 = 1.00001472.
In step 8, raise this rate the power of the number of days in the loan and duplicate by the principal: 1.00001472^1 x $1,000,000 = $1,000,014.72.
Ultimately, take away the two aggregates to recognize the profit acquired by the bank from utilizing the swap: $1,000,014.72 - $1,000,013.89 = $0.83.

Features

The interest of the overnight rate portion of the swap is accumulated and paid at reset dates, with the fixed leg being represented in the swap's value to each party.
Like other interest rate swaps, an interest rate bend must be delivered to decide the current value of cash flows.
The floating leg's current value not set in stone by one or the other compounding of the overnight rate or by taking the geometric average of the rate over a given period.