How Overnight Index Swaps Compound Floating Rates

Summary

The document compares overnight indexed swaps (OIS) with conventional interest rate swaps. Both exchange fixed and floating payments, but the floating leg is constructed differently. A conventional swap generally uses a single term-rate fixing for each accrual period, such as a three-month benchmark, whereas an OIS uses overnight rates compounded across the accrual period.

Because daily settlement would be operationally burdensome, the described OIS convention combines the daily overnight observations into a compounded amount paid at the end of the period, or at an anniversary date. This makes OIS similar in broad purpose to a swap with a floating leg, but not simply a short-term version of a vanilla IRS. The explanation is conceptual and does not cover specific market conventions, day-count rules, payment lags, or pricing and discounting details.

Key ideas

• OIS and conventional interest rate swaps both exchange fixed and floating cash flows.
• A vanilla IRS typically uses a term-rate fixing for each accrual period.
• An OIS compounds daily overnight rates over the accrual period and settles the resulting amount periodically.
• The products are conceptually related, but their floating-leg mechanics differ.

Tags

# Can we think of Overnight Index Swaps as short-term IRS?


# Can we think of Overnight Index Swaps as short-term IRS?












OIS are a series of fixed-rate cashflows discounted at the overnight rate, swapped for overnight (floating) rate.

IRS are similarly discounted fixed-rate cashflows, swapped on an IBOR-floating rate.

Since both of them are used to swap between fixed rate payment and float rate payment, can we think of OIS as short-term IRS?

## Answer by nbbo2 (score 4, accepted)

https://quant.stackexchange.com/a/55302

The concept is similar, but the mechanics are slightly different. Making a quarterly payment based on 3-month Libor is fine, but making daily payments of the overnight rate is inconvenient (too much work in the back-office making and checking the payments), so a single payment is made at maturity (or on the annual anniversary of the swap's inception), based on a mathematical geometric averaging formula applied to all the overnight rates.

## Answer by David Duarte (score 6)

https://quant.stackexchange.com/a/55299

An Interest Rate Swap (IRS) normally refers a swap between a fixed rate and a floating rate. Floating rate being a single fixing for each accrual period and payment.

An overnight indexed interest-rate swap will have the daily overnight index compounded throughout the accrual period. A vanilla IRS will not compound during the accrual, being a term rate.

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.