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An overnight index swap (OIS) is a kind of derivative contract that enables two parties to trade the difference between a fixed interest rate and a floating interest rate based on an overnight index, like the Federal Funds Rate in the United States. Typically, banks and other financial institutions utilize OIS contracts to control their overnight funding costs and protect themselves against interest rate changes.
In an OIS agreement, one party promises to pay the other a fixed interest rate on a fictitious principal sum, and the other party promises to pay a floating rate depending on the overnight index. The overnight rate—the interest rate at which banks lend and borrow money from one another over the course of one day—is used to determine the floating rate. The overnight rate is subtracted from one, the notional amount is multiplied, and the result is the OIS rate.
Each day's settlement of an OIS contract involves the parties exchanging, based on the notional amount, the difference between the fixed and floating rates. The party receiving the fluctuating rate will reimburse the other party for any difference if the floating rate is more than the fixed rate. If the fixed rate is greater than the variable rate, the party receiving the fixed rate is responsible for compensating the other party for the difference.
Financial institutions frequently employ OIS contracts to control their overnight funding expenses since they let banks lock in a set rate of interest for their overnight funding requirements. OIS contracts can also be used as a hedge against interest rate changes, especially in markets with unstable interest rates.
OIS contracts, though relatively straightforward in comparison to other derivative contract types, are crucial to the financial system because they assist banks and other financial institutions in managing their financing costs and mitigating risks related to interest rate swings.
