What is an overnight index swap?

An overnight index swap (OIS) is an interest rate derivative in which one counterparty agrees to pay a fixed rate while the other pays the geometric or arithmetic average of a daily overnight reference rate over the life of the contract. In the United States, the overnight rate is now SOFR (previously the effective federal funds rate), making OIS swaps the market's primary tool for pricing the expected path of Fed policy.

The fixed leg of an OIS represents the market's average expected overnight rate over the contract's tenor. If the 1-year OIS rate is 4.50%, the market is pricing in an average overnight rate of 4.50% over the next 12 months. By comparing OIS rates at different tenors, analysts can extract the implied timing and magnitude of future rate cuts or hikes. This makes the OIS curve the most direct market-based measure of monetary policy expectations.

The OIS market is also central to credit risk measurement. The spread between LIBOR (or its successors for term rates) and the OIS rate isolates the credit and liquidity risk premium in bank funding markets. A widening LIBOR-OIS spread historically signals growing interbank stress, as it did during 2007-2008 and again briefly in March 2020.

For institutional investors, OIS rates serve as the foundation for discounting future cash flows. Since the 2008 crisis, derivatives market participants adopted OIS-based discounting rather than LIBOR-based discounting for collateralized derivatives, reflecting the reality that collateral posted in margin accounts earns the overnight rate. This seemingly technical change had profound implications for the valuation of trillions of dollars in interest rate swaps, making OIS the bedrock reference rate for modern fixed-income analytics.