The Polish market of swaps indexed to the overnight rate (Eng. Overnight index swap, abbreviated as OIS) is a very young market though a very prospective one too. Its beginning was not easy. Some market participants did not believe at all in the possibility of the market being created for the Polish currency. It suffices to mention that the first transactions were preceded by ca. 4 years of meetings, debates and agreements to realize how bad the situation was. It was mainly due to the absence of a reliable reference index. What made the matters worse were system barriers which the bankers encountered in their banks and which prevented concluding transactions “right away”. Most often internal regulations required totally separate procedures and business guidelines which had to be created from scratch. No wonder, however, the market was becoming increasingly skeptical. On the other hand, high volatility of 1-day money market rates and chronic absence of limits for deposit transactions made the topic resurface. OIS transactions offer an opportunity for ideal hedging of cash positions in the periods of the smallest volatility. They also allow to take positions more efficiently depending on the expectations of the future money market curve (derivative limits weigh much less on credit risk exposure than standard credit utilization). A long period of waiting for the product along with the benefits it may bring, resulted in the bank’s high interest when the first OIS transactions were concluded (March 2004). The fate of the market is not decided yet though its further growth seems more likely than the probability of its collapse.

This article is aimed at bringing overnight index swaps (further referred to as OIS) closer to a wider group of customers. It was written in response to the growing interest in this product among individuals with no professional interest in the dealing room, and for everybody looking for comprehensive, cumulative information on that topic. The text includes full description of the product, basic ways of its pricing and information on the Polish OIS market.

Starting with the definition: OIS is a swap of fixed interest rate in exchange for a floating interest rate where the floating rate is determined on the basis of the daily reference 1-day rate (in Poland it is Polonia rate). It is a contract of swapping two money flows.

- Fixed leg – which is an one-off payment, i.e. interest calculated acc. to the fixed, defined in the contract, interest rate on a certain agreed nominal value.
- Floating leg – which is a one-off payment, i.e. interest accrued daily, calculated based on the ON rate on the agreed nominal amount of the contract.

(Interest) payments are swapped at the contract maturity by way of net settlement. In practice, the settlement takes place on the first business day following the maturity date. This is dictated by the fact that Polonia rate is an average interest rate calculated on one-day transactions concluded on a given day, weighted by their nominal amounts.

Terms of standard OIS contracts match the terms of standard deposits in the inter-bank money market (from one week to one year). The fashion of quoting the prices of these contracts is the same as for deposits. In particular, the beginning and end of the OIS interest period are the same as for a deposit with the same maturity date.

Further comparison to deposits shows that it is true that if it is possible to borrow cash with the same maturity and the same interest rate as in the case of a swap, and if the cash is re-invested in the market each day at an interest rate equal to a given index, and if the amount of cash paid at maturity is exactly the same as the return on the swap transaction then OISs are a perfect hedge for such a financial instrument. From the economic point of view, receiving a fixed interest rate in OIS is like lending money to someone while paying such a rate can be compared to borrowing money. In dealers’ speak, buying OIS means paying a fixed interest rate and receiving a floating rate. In the case of selling OIS it’s the other way round.

OIS swaps allow to change risk profile related to the change in interest rates of a given portfolio without any cash involved and with a minimum utilization of credit limits. These features are conducive to flexible interest rate risk management and allow to actively trade in OIS as a financial instrument.

OIS enhance liquidity with respect to money market curves as well mitigating the system risk referring to cash transactions. They also help enhance efficiency in the management of short-term liquidity. Reswapped term deposits are obtained based on the floating ON rate which makes them independent of the fixed interest rate. The bank first pays fixed interest rate on the deposit to receive it back through an OIS transaction while the interest is calculated according to the floating ON rate (it is a big advantage in the case of positive sloped yield curves).

The key purposes of using OIS are:
- Interest rate risk management – OIS are derivative instruments of the money market and as such are characterized by a much bigger liquidity than the money market itself, especially for long tenors. OIS are usually quoted with smaller spreads which enables more precise calculation of forward-forward rates to create more accurate forward curves reflecting market expectations of interest rates going forward (in developed markets the beginnings of the curves are designed by means of 1M or 3M futures and require interpolation; it can be avoided thanks to OIS rates).

- Carry trade – OIS transactions make an excellent tool for the so-called carry trade on the short end of the yield curve. If the dealer decides that the overnight forward curve is too flat they can pay OIS (they pay a fixed rate by receiving a floating one). If, however, the trader believes that this curve is too steep, they can sell OIS by receiving a high fixed rate and paying a floating rate which (at least according to his expectations) drops every day.

- Swapping maturity terms through OIS – this usage can most straightforwardly be presented by means of an example where assets with a 3M maturity are swapped for a 1 week rate. To achieve this, a 3M rate of a given asset would have to be reswapped for a 1 day interest rate by way of buying a 3M OIS and next by selling a 1 week OIS a fixed 3M interest rate would have to be reswapped for a fixed 1 week interest rate. This way, the 3M return rate on the asset offsets the OIS 3M fixed rate (most often leaving some spread), similarly both 1-day floating rates offset. Only 1 week fixed interest rate remains. In the same way, we can swap any maturity terms up to 1 year, and even longer (there are markets with OIS curves of up to two years).

- Hedging the cost of funding, if the cost is a 1 day reference index – purchase of OIS hedges the Bank against the increase of 1 day deposit rates. This is a more accurate hedge than using other term derivatives. This is mainly due to the fact that the other allow for the so-called squeezes or temporarily cheap short money to a very small extent. Squeeze is a situation where the shortest term interest rates grow violently as there is less cash in the banking system than apparently necessary given the must to keep the obligatory reserve on deposits at a specific level. Temporarily cheap money occurs when the amount of cash in turnover is much higher than required.

- Managing liquidity and swapping term liabilities – Banks like to manage liquidity on the ON value date given high flexibility of the strategy. With the growing yield curve, a big role is also played by the economic aspect. In such circumstances, term deposits create unwanted costs relative to short-term deposits. Of course the obtained funds can be allocated at the further end of the curve and funding can be raised from ON, however such a strategy causes the so-called “blockage” of credit lines and significantly increases the bank’s operational risk. OIS seem to be an ideal solution to this problem. They enable sourcing funds for long terms and swapping them for a 1 day index without the necessary utilization of credit, liquidity limits, etc.

Apart from the basic purposes of using OIS, the following risks related to OIS turnover should also be taken into account:
- Settlement risk – much smaller than in the case of classic deposits. It merely includes the risk of losing the difference between interest cash flows arising from the fixed and floating leg of the swap , accrued over its life. The risk is usually estimated in the tenths of the nominal’s percentage (for deposits it is 100%).
- Market risk – OIS curve on developed markets is usually 3-10 basis points below the cash curve. This base reflects the fact that OIS are derivatives which only involve interest flows without capital movement (lower risk premium) and do not require funding. For longer terms, the effect of capitalizations should also be taken into account. The base widens in the periods of the less liquid market.
- Liquidity risk – in the developed markets, the risk practically does not exist. OIS markets usually significantly outperform the corresponding deposit markets in terms of the turnover scale.

In Poland this risk should now be treated as one of the basic risks which can lead the OIS market to extinction in an extreme case. As it was mentioned in the introduction, the Polish OIS market tried to kick off a few years ago but the entire undertaking ended with a fiasco for the very reason of most markets’ unreadiness to deal. Also today, the whole market is created by a few banks and if this situation does not change the history may be repeated. Other banks are willing to join the process of creating this market and if the system problems do not stifle the willingness perhaps pretty soon OIS will be actively quoted at least by other participants who make up the WIBOR index.

There is something to fight for at least given the prospects offered by the market. In the developed markets not only simple OIS rates are quoted but also their structures like forward-forward. Over a few years, it could also be the target of the banks operating in Poland. Not only would it make the Polish market more liquid but would also prepare local players to enter the EURO zone where such transactions are a common feature.

The basic valuation of the OIS settlement amount  can be calculated by means of two simple formulas:
OIS fixed interest payments are calculated according to the simple interest formula:
O = (NP*R*D)/100*DB

O – the total of interest due
NP – base amount
D – OIS term (in days)
R – Agreed fixed interest rate (in %)
DB – base number of days

For the Polish market, the base number of days in OIS transactions is 365 days.

OIS floating interest payments are calculated according to the daily capitalization formula:
NP – base amount
On – OIS index for the “n-th” dy of the swap
Dn – number of days for the “n” term

The settlement amount is the absolute value of the difference between the two values above.

To summarize, the key advantages of OIS are:
- Easy use,
- The fact it is the only OBS alternative for cash transactions,
- Minimum credit risk,
- Higher liquidity and narrower spreads relative to deposits,
- No necessity for excessive “pumping” of the B/S,
- System risk mitigation.

To conclude, it is also worth mentioning that OIS dealings are usually based on the International Swaps and Derivatives Association agreement. The ISDA 1991 definition along with subsequent amendments defines the reference of the floating interest rate, used for all the key currencies, and is updated once new currencies are added.

In Poland it is supplemented by the recommendation of Stowarzyszenie Dealerów Bankowych ACI POLSKA on OIS dealings issued in 2004.

Author: Bartłomiej Małocha