Overnight Indexed Swap

An overnight indexed swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index rate over every day of the payment period. The index rate is typically a central bank rate or equivalent, for example the Federal funds rate in the US. Overnight Index Swaps are instruments that allow financial institutions to swap the interest rates they are paying without having to change the terms of contracts in place with other financial institutions.

The fixed rate of OIS is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR), because it is based on a central bank rate and only the net difference in interest rates is paid at maturity of the swap so there is limited counterparty risk.

The LIBOR–OIS spread is the difference between LIBOR and the (OIS) rates. The spread between the two rates is considered to be a measure of health of the banking system. It is an important measure of risk and liquidity in the money market, considered by many, including former US Federal Reserve chairman Alan Greenspan, to be a strong indicator for the relative stress in the money markets. A higher spread (high Libor) is typically interpreted as indication of a decreased willingness to lend by major banks, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes.

The LIBOR–OIS spread has historically hovered around 10 basis points (bps). However, in the midst of the financial crisis of 2007–2010, the spread spiked to an all-time high of 364 basis points in October 2008, indicating a severe credit crunch. Since that time the spread has declined erratically but substantially, dropping below 100 basis points in mid-January 2009 and returning to 10–15 basis points by September 2009.