![]() ![]() ![]() You see, the overnight rate in constantly changing, and you will pay a different interest rate at 6:00 am than you will pay at 11:00 am. The question is, how do you determine what rate to use when each institution is paying a slightly different rate based on what time of day they have to determine their payment. One of the key pieces of information analysts watch is the interest rate the institutions who have loans with variable interest rates are paying. The overnight index swap (OIS) market is quite large, and the movements in this market can provide a lot of information for economists and analysts who are trying to understand what is happening in the global financial markets. Of course, if Institution #1 ends up paying an average interest rate of 2.2 percent on its loan and Institution #2 ends up paying an interest rate of 2 percent, Institution #2 will pay Institution #1 the equivalent of 0.2 percent (2.2 – 2.0 = 0.2) because, according to their agreement, they swapped interest rates. For example, if Institution #1 ends up paying an average interest rate of 1.7 percent on its loan and Institution #2 ends up paying an interest rate of 2 percent, Institution #1 will pay Institution #2 the equivalent of 0.3 percent (2.0 – 1.7 = 0.3) because, according to their agreement, they swapped interest rates. To set up the swap, both institutions would agree to continue servicing their loans, but at the end of a specified time period-one month, three months and so on-whoever ends up paying less interest will make up the difference to the other institution. In this case, these two institutions could create an overnight index swap (OIS) with each other. As it turns out, Institution #1 would much rather be paying a fixed interest rate on its loan, and Institution #2 would much rather be paying a variable interest rate-based on the overnight rate-on its loan, but neither institution wants to go out and get a new loan and they can’t renegotiate the terms of their current loans. Institution #2, on the other hand, has a $10 million loan that it is paying interest on, but the interest on this loan is based on a fixed, short-term rate of 2 percent. Imagine Institution #1 has a $10 million loan that it is paying interest on, and the interest is calculated based on the overnight rate. This may sound a bit strange, but here is how it works. Typically, when two financial institutions create an overnight index swap (OIS), one of the institutions is swapping an overnight interest rate and the other institution is swapping a fixed short-term interest rate. 6, pp. 722–740, Online at zeno.Overnight Index Swaps (OIS) are instruments that allow financial institutions to swap the interest rates they are paying without having to refinance or change the terms of the loans they have taken from other financial institutions. ![]() ![]()
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