OVERNIGHT INDEX SWAP (Syllabus: GS Paper 3 - Economy)
Context: The Reserve Bank of India (RBI) is currently reviewing the investment limit for foreign investors in the overnight index swap (OIS) market. This move aims to adjust regulatory frameworks and enhance market dynamics.
Overnight Index Swap
- Definition: An OIS is a derivative instrument where returns from a fixed rate asset are exchanged for a pre-determined published index of a daily overnight reference rate over an agreed period.
- Purpose: The primary goal of an OIS is to manage interest rate risk, particularly fluctuations in the overnight lending rate.
o Liquidity Indicator: The OIS-Libor credit spread reflects system liquidity.
o Wide Spread: A wider spread indicates tightening liquidity in the system.
o Narrow Spread: A narrower spread suggests better liquidity in the system.
- Rate Calculation: The OIS rate is calculated daily based on the average interest rate paid by institutions for overnight loans.
- OIS Work
o Functionality: Financial institutions use OIS to swap interest rates without refinancing or altering the terms of their existing loans.
o Swap Mechanism: In an OIS, one institution swaps a floating overnight interest rate, while the other swaps a fixed short-term rate. At the end of the agreement, the institution paying less interest compensates the other.
