An Overnight Indexed Swap (OIS) (an interest-rate derivative) is a fixed/floating interest rate swap with the floating leg computed using a published overnight rate index, typically considered less risky than the corresponding interbank rate (LIBOR), in the case of the USD, the Fed Funds Effective Rate.
Two parties agree to exchange at maturity the difference between interest accrued at the fixed rate & interest accrued at the compounded floating rate on the agreed notional amount of the swap.
Net payment is made two business days after maturities
The basis convention is Annual ACT/360 (or Actual/360)
(Interest = Principal x CouponRate x Factor)
(Factor = (Actual days between the start and end dates inclusive)/360) (i.e. Assumes 360 day year)
swap receiver... receives fixed rate payments (and makes floating rate payments)
swap payer... receives floating rate payments (and makes fixed rate payments)
An OIS acts as a perfect hedge for a cash instrument...
Cash can be lent daily (i.e. in a daily accruing interest bearing account) for daily interest receipts. In contrast, the swap receiver effectively makes daily interest payments. If the daily rates 'line up,' the cash inflow can be matched with the cash outflow, the the OIS receiver has hedged the daily rate change uncertainty with a fixed rate.
OIS rates (or, in particular, the difference or 'spread' between OIS rates & LIBOR) are an important measure of risk & liquidity in the money market, considered by many to be a strong indicator for the relative stress in money markets. A higher spread is typically interpreted as an indication of decreased willingness to lend by major banks, while lower spread indicates higher liquidity in the market. The spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions & general availability of funds for lending purposes
