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An overnight index swap is a very specific type of derivative. It involves two parties agreeing to exchange the interest they pay on particular investments, which is usually done when each party wants to vary the level of risk it is exposed to. In this case, one of these investments involves the overnight index, which is a measure of the interest rates available for commercial loans. There is a strong economic theory that the difference between the rates used in an overnight index swap and the rates charged by banks to loan one another money is an indicator of the availability of credit in the money markets.
An overnight index swap is a type of interest rate swap. This is where two parties agree to swap the money they would pay as interest on a specified investment. These can be real investments or simply hypothetical examples. There is a wide variety of possible set-up with interest rate swaps as the investment on either side can be either fixed or variable, and the two investments can be in the same or different currencies. Generally, one party will make the deal so that it limits risks, such as the risk of variable interest rates increasing, while the other party will make the deal because it feels more confident and wants to increase its potential profits.
In an overnight index swap, the investment used for one party in the deal is an overnight index. This is an average of the rates charged by financial institutions to borrow money from one another overnight. This takes care of the variations in cashflow during the day as customers deposit or withdraw money, and makes sure the institution has enough cash on hand for the next day's business.
In the United States, the index used is based on the Federal Funds Rate. This is the Federal Reserve's target rate for overnight lending between banks. The Federal Reserve intervenes in the market for overnight lending to try to manipulate the market rate to meet its target.
The index figure is calculated as the geometric mean. This is similar to the arithmetic mean, which most people think of as an "average," but instead of adding the figures and then dividing them by the number of figures, the average is found by multiplying the figures together, then dividing them by the relevant root; if there are two figures, the square root is taken, if there are three figures, the cube root is taken, and so on.
Investors often pay close attention to the rates used in an overnight index swap, and the LIBOR rate that is used for direct overnight loans between banks. LIBOR stands for London Interbank Offered Rate. Although this rate is derived from the London market for overnight loans, the most significant difference between the Federal Funds Rate and LIBOR is that LIBOR is purely determined by the markets, with no attempt by officials to manipulate it.
Many investors follow the theory that LIBOR lending is riskier because large amounts of real cash are at stake, while an overnight index swap simply involves variations on interest charges, which may even be hypothetical. The theory is that overnight index swap rates will generally be more stable, and if the LIBOR rate varies from it by a large degree, it's a sign that banks are more wary about lending to other banks. In turn, this suggests there will be a tightening of credit availability to borrowers down the line such as businesses. The theory was illustrated starkly in 2008, when a particularly large variation between the overnight index swap rates and the LIBOR rate came at the height of what was described as a "credit crunch."
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