How to hedge overnight rate risk without using balance sheet capital

By Margaret Elliott

In the last two years, a little-known short-term money market product has swept through Europe—overnight indexed swaps (OIS). Although these products were developed in the United States as "call money swaps,” they have long been used in France. OIS allow users to hedge overnight rates when they are volatile or coming under pressure. Although they are used by corporates and investors, the instruments are particularly attractive to banks, which use them to manage their short-dated funding gap risk off the balance sheet and at minimal credit risk. Before OIS, there was no way to hedge without eating up precious balance sheet capital.

An OIS is a fixed- to floating-interest-rate swap, where the floating arm is tied to a daily overnight rate reference. The term of the product, which is a true money market instrument, ranges from one week to one year. The two parties agree to exchange at maturity the difference between interest accrued at the agreed fixed rate and interest accrued through compounding the floating index rate. There is no exchange of principal.

The French first took to the instruments in the late 1980s. Overnight interest rates had shot way up, and the only way to access the yield was to buy a 90-day OIS and receive the overnight rate. In early 1995, an OIS market began in Italy. Last year, markets were opened in Spain and Germany. This year the United Kingdom came on stream, and Japan is scheduled for late this year if a few administrative kinks can be worked out in time.

The biggest users to date have been banks, because OIS are the perfect hedge for their repo and short-term funding desks. "Until OIS there was no way for repo traders to manage their interest rate risk at this short a term,” says William Porter, head of marketing for short term interest rate products at JP Morgan in London. "Think of term repo. Banks don't do it for the income—they do it to move collateral in and out. But they do have overnight interest rate risk, and OIS allows them to manage that risk.”

Potentially, an OIS is a powerful tool for both corporate asset and liability management and investor-funding risk management. In the case of a cash-rich corporate, an OIS can be used to allocate a portion of that pool of cash to assets indexed to a daily rate. When the yield curve is inverted, corporates can use this instrument to pull the average duration of their short-term portfolio back as short as possible, thus increasing yields.

Although few investors are using OIS at the moment, theoretically the instrument can be a more effective hedge than futures against sudden, sharp rises in fund rates. That's because the shortest available future is a three-month contract that refers to a final maturity three to six months in the future. "Funding squeezes,” says Porter, "usually occur overnight. OIS, where you pay fixed and receive floating, exactly compensate for rises in overnight rates.”

In markets such as France, where $20 billion in OIS is outstanding daily, liquidity is quite high. "The bid/offer spread is usually three basis points for large-size tickets—sometimes it can be even less,” says Pierre Renom, a trader at Banque Nationale de Paris in Paris. And OIS spreads are significantly less than the 12 basis points found in currency deposits.

In Germany and Italy, where the outstanding OIS is $1 billion or so, bid/offer spreads of five basis points are expected to converge to FRA rates. "We expect Deutsche mark OIS spreads of three basis points by the end of the year,” says Deutsche Morgan Grenfell trader Bernard Sorries. In Germany, says Sorries, it is mainly a bank instrument, attractive because of the minimal counterparty credit exposure. "Because the exposure is only for the amount of any profit, credit exposure is usually 1 percent of the nominal value—much less than a cash transaction and lower than in a LIBOR swap,” says Sorries.

Cash Flow of an Overnight Index Swap

Example: 3-month OIS in Italian lira at 7.22% on April 4, 1997
Dates	Floating Leg	Fixed Leg	Net payment
8 April 1997
9 July 1997 (N+1)	–N x Rfloat% x 91/365	N x 7.22% x 91/365	N x (7.22% – Rfloat%) x 91/365
N = notional of swap • Rfloat = compounded money rate
The fixed-rate receiver will make a net payment to its counterparty if Rfloat is greater than 7.22 percent and will receive a net payment if Rfloat is less than 7.22 percent. There is no exchange of principal.