Overnight Index Swap

Discounting
The overnight index swap (OIS) has come into the
spotlight recently, due to the widening of the Libor-OIS
spread. For example, the Economist recently reported:

WATCHING financial markets can be like watching a

horror film. A character walks into the darkness alone. A
floorboard creaks. The latest spooky sign is the spread
between the three-month dollar London interbank offered
rate (LIBOR) and the overnight index swap (OIS) rate. It
usually hovers at around 0.1%, but has recently climbed
to 0.6% (see chart). As it widens, bankers are bracing for
a jump scare.

To see why, consider what each rate represents. LIBOR is

the rate that banks charge other banks for unsecured
loans. The OIS rate measures expectations for the federal
funds rate, which is set by the central bank. As LIBOR
rises above the OIS rate, that suggests banks fear it is
getting riskier to lend to each other. (The gap was 3.65
percentage points in the depths of the crisis, after
Lehman Brothers filed for bankruptcy.) Read more
Libor-OIS spread as at May 2, 2018. Source: Bloomberg
What exactly is an overnight index swap?

An overnight index swap is a fixed/floating interest rate

swap that involves the exchange of the overnight rate
compounded over a specified term and a fixed rate. The
floating leg of the swap is related to an index of an
overnight reference rate, for example Canadian Overnight
Repo Rate Average (CORRA) in Canada or Fed Funds rate
in the US.

Usually, for swaps with maturities of 1 year or less there is

only one payment. Beyond the tenor of 1 year, there are
multiple payments at regular intervals. At the inception of
the swap, the par swap rate makes the value of swap zero.
That is, the net present value (NPV) of the fixed leg equals
the NPV of the floating leg,
where N denotes the notional amount of the swap,

Ri-1,i  is the forward OIS rate,

Zi is the discount factor at time ti

is the daily accrual factor, and

 sK is the par swap rate of a swap with maturity tK.

The OIS discount factors (DF) are often used to value

interest rate derivatives that require a posting of
collateral.  The OIS discount factor curve is built by
bootstrapping from the short maturity and long maturity
overnight index swap rates in order of increasing
maturity.  The processes for backing out the discount
factors from the short and long maturity swap rates are,
however, different.

In the short end of the curve, given that there is only 1

payment, the discount factor is calculated based on the
spot rates. At the long end of the curve, the DF curve is
determined as follows,

 Payment dates are generated at each 6 months (or a

year, depending on the currency) from the time zero
up to 30 years,
 Par swap rates are determined at each payment date.
To obtain the par swap rates for the payment dates
where there are no swap quotes, one linearly
interpolates the par swap rates in order to complete
the long end of the swap curve,
  Using the par swap rates at each payment date,
discount factors are obtained by solving a recursive
equation.
This is just an introduction to OIS discounting. The
process for building an OIS discount curve involves many
technical details. We are happy to answer your questions.