Overnight Index Swap

DEFINITION of 'Overnight Index Swap'

An interest rate swap involving the overnight rate being exchanged for a fixed interest rate. An overnight index swap uses an overnight rate index, such as the Federal Funds Rate, as the underlying for its floating leg, while the fixed leg would be set at an assumed rate. Overnight index swaps are popular amongst financial institutions for the reason that the overnight index is considered to be a good indicator of the interbank credit markets, and less risky than other traditional interest rate spreads.

BREAKING DOWN 'Overnight Index Swap'

Generally short-term, the interest of the overnight rate portion of the swap is compounded and paid at reset dates, with the fixed leg being accounted for in the swap's value to each party. The floating leg's present value is determined by either compounding of the overnight rate or by taking the geometric average of the rate over a given period. Like other interest rate swaps, an interest rate curve must be produced to determine the present value of any cash flows.

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