Overnight Index Swap & Calculation
An index swap refers to a hedging contract in which a party exchanges a predetermined cash flow with a counter-party on a specified date. An overnight index swap uses an overnight rate index such as the federal funds rate as the underlying rate for the floating leg, while the fixed leg would be set at a rate agreed on by both parties. The floating leg's present value (PV) is determined by either compounding of the overnight rate or by taking the geometric average of the rate over a given period. Overnight index swaps are popular among financial institutions because the overnight index is considered to be a good indicator of the interbank credit markets and less risky than traditional interest rate spreads. The overnight index swap denotes an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. The interest of the overnight rate portion of the swap is compounded and paid at reset dates, with the fixed leg being accounted for in the swap's value to each party.
What Is an Overnight Index Swap?
An index swap refers to a hedging contract in which a party exchanges a predetermined cash flow with a counter-party on a specified date. A debt, equity, or other price index is used as the agreed exchange for one side of this swap.
An overnight index swap applies an overnight rate index such as the federal funds or London Interbank Offered Rate (LIBOR) rates. Index swaps are specialized groups of conventional fixed-rate swaps, with terms that can be set from three months to more than a year.
How Does an Overnight Index Swap Work?
The overnight index swap denotes an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. An overnight index swap uses an overnight rate index such as the federal funds rate as the underlying rate for the floating leg, while the fixed leg would be set at a rate agreed on by both parties. The interest of the overnight rate portion of the swap is compounded and paid at reset dates, with the fixed leg being accounted for in the swap's value to each party.
The floating leg's present value (PV) is determined by either compounding of the overnight rate or by taking the geometric average of the rate over a given period.
Overnight index swaps are popular among financial institutions because the overnight index is considered to be a good indicator of the interbank credit markets and less risky than traditional interest rate spreads.
How to Calculate an Overnight Index Swap
Eight steps are applied in calculating a bank's dollar benefit from using an overnight index swap.
Related terms:
Amortizing Swap
An amortizing swap is an interest rate swap where the notional principal amount is reduced at the underlying fixed and floating rates. read more
Day-Count Convention
A day-count convention is a standardized methodology for calculating the number of days between two dates. read more
Federal Funds Rate
The federal funds rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight. read more
Fixed Interest Rate
A fixed interest rate remains the same for a loan's entire term, making long-term budgeting easier. Some loans combine fixed and variable rates. read more
Geometric Mean
The geometric mean is the average of a set of products, the calculation of which is commonly used to determine the performance results of an investment or portfolio. read more
Inflation Swap
An inflation swap allows one to transfer inflation risk to a counterparty in exchange for a fixed payment. read more
Present Value – PV
Present value is the concept that states an amount of money today is worth more than that same amount in the future. In other words, money received in the future is not worth as much as an equal amount received today. read more
Principal
A principal is money lent to a borrower or put into an investment. It can also refer to a private company’s owner or a one of a deal’s chief participants. read more
Reset Date
Reset date is a point in time when the initial fixed interest rate on an adjustable rate mortgage (ARM) changes to an adjustable rate. read more
Swap Rate & Examples
The swap rate denotes the fixed portion of a swap as determined by an agreed benchmark and contractual agreement between party and counter-party. read more