An overnight index swap (OIS) is an over-the-counter* derivative in which two parties agree to exchange, or swap, for an agreed period, a fixed interest rate determined at the time of the trade for a floating rate** that will vary over time.
Market participants predominantly use the OIS market for hedging activities, which are often related to risk management. Specifically, participants can use the OIS to hedge either their funding costs or their exposure to short-term interest rate movements.
The OIS market can also be used to alter the term structure of a portfolio or for taking a speculative position on the future path of the Bank of Canada’s target overnight rate. (Overnight index swaps provide a gauge of what the overnight rate is expected to average over a given period.)
Related to the speculative and hedging functions of the OIS, the fixed-rate portion is also used by some market participants to derive market expectations of the Bank’s future policy rate changes. If the duration of the swap extends over a Bank of Canadainterest rate meeting, for example, the difference between the fixed rate and the current overnight rate can be used to calculate the market expectations of a future change in policy rates.
The OIS has several advantages over other money market instruments in calculating expectations. Unlike other financial instruments, it is directly linked to the Canadian overnight rate. Furthermore, given that they are derivatives instruments, the supply of OIS contracts is not fixed. Supply factors can occasionally influence the pricing of other instruments, such as bankers’ acceptances (BAs).
The use of the OIS market to gauge expectations also presents some challenges. At times there is a lack of price information or market depth in the OIS market, particularly in farther-dated contracts. Moreover, if the CORRA rate were expected to deviate from the overnight target, gauging expectations of future interest rates would become more difficult.