Skip to content
All library documents

Choosing IRS or OIS to Hedge Floating Interest Rates

Article Quant Q&A · Author: Shyam
Read the original

Summary

The document explains how interest rate swaps (IRS) and overnight indexed swaps (OIS) differ in access and hedging use. Counterparty type does not by itself limit access to OIS: a corporate with an ISDA agreement to trade IRS with a bank can generally trade OIS as well.

For a corporate loan tied to LIBOR, an IRS can convert the floating exposure to fixed; using OIS instead leaves LIBOR/OIS basis risk. OIS rates are generally below LIBOR, but this is not a rule. The example notes that EURIBOR was below EONIA for an extended period, attributing the difference to distinct fixing methods and liquidity rules that affected demand for short-term borrowing. The discussion is conceptual and gives no pricing model or quantitative evidence beyond that market example.

Key ideas

  • Corporate counterparties may trade OIS as well as IRS, subject to their trading arrangements.
  • An IRS is a direct hedge for a loan whose floating rate is LIBOR.
  • Using OIS to hedge LIBOR exposure introduces LIBOR/OIS basis risk.
  • OIS rates are often below LIBOR, but relative levels can reverse across benchmarks and market conditions.

Tags

Fixed incomeDerivatives pricingRisk management
Full text
# Difference between IRS and OIS


# Difference between IRS and OIS












Is the understanding right that OIS can be accessed only by banks whereas IRS is for corporates.

Also, since corporates borrow at Libor + spread, to hedge Libor I use IRS.

Banks can borrow overnight at the overnight rate for which I use OIS to fix.

It will also always be that OIS is lesser than IRS, right?

## Answer by Attack68 (score 3)

https://quant.stackexchange.com/a/45155

A corporate that has an ISDA master agreement to trade Interest Rate Rwaps (IRSs) with a bank will undoubtedly be capable of also trading Overnight Indexed Swaps (OISs), as will any type of counterparty for that matter.

A corporate whose loan is tied to floating LIBOR will hedge using an IRS to convert to fixed. Hedging with an OIS would introduce unnecessary LIBOR / OIS basis risk.

The OIS market is for overnight unsecured lending. How the OIS fix is determined varies in different currencies.

Generally OIS is lower than LIBOR. However this is not always true. 1M EURIBOR was lower than EONIA (EUR OIS) for a prelonged period of time, primarily for two reasons; the inherent differences by which EONIA and EURIBOR fixings were calculated, and the LCR (Basel III Liquidity Coverage Ratio) which creates a natural aversion to borrowing money for a term of only 1M, hence the demand is restricted and the rate fell.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.