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Source- This post on Overnight Index Swap (OIS) has been created based on the article “Monetary policy review: FPI investment limit in OIS market under review” published in “Business Standard” on 12 August 2024.
Why in News?
Recently, the Reserve Bank of India (RBI) has been reviewing the investment limit for foreign investors in the overnight index swap (OIS) market.
About Overnight Index Swap (OIS)
| Aspects | Description |
| About | An OIS is a financial derivative that allows two parties to exchange a fixed interest rate for a floating rate linked to an overnight index. |
| Purpose | OIS contracts are used to manage interest rate exposure, ensure financial stability, and potentially profit from interest rate predictions. |
| Party involved | Fixed-Rate Payer: Pays a predetermined, constant interest rate throughout the swap’s duration. Floating-Rate Payer: Pays a variable interest rate based on an overnight index, which fluctuates daily. |
| How it works | 1. Notional Principal: The swap is based on a notional principal amount used to calculate interest payments, but this principal is not exchanged between the parties. 2. Interest Rate Payments: At the end of the swap’s term, the parties exchange the difference between the fixed and floating interest payments. 3. Settlement: The party with the higher interest obligation compensates the other party for the net difference. 4. Examples include the Federal Reserve’s federal funds rate (U.S.) and the European Central Bank’s EONIA rate (Eurozone). |
| Application | 1. Hedging: Financial institutions use OIS to protect against short-term interest rate fluctuations. 2. Speculation: Traders may speculate on future interest rate movements to profit from the difference between fixed and floating rates. |
| Scenario in which it can be undertaken | A bank expecting an increase in short-term interest rates might enter an OIS to pay a fixed rate while receiving a floating rate, thus hedging against rising borrowing costs. |
| Advantages | 1. Lower Counterparty Risk: Only the net difference in interest payments is exchanged, reducing risk. 2. Liquidity: OIS markets are typically liquid, making it easier to enter or exit positions. |
UPSC Syllabus: Indian Economy
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