How does an OIS work and why has it replaced LIBOR swaps?

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AcadiFi · Accepted Answer

An Overnight Index Swap exchanges a fixed rate for the compounded daily overnight rate (SOFR in USD, ESTR in EUR, SONIA in GBP) over each calculation period. Cash flows are netted at each period end. Example: Larkspur Treasury enters a 1-year OIS on $75M receiving fixed 4.35%, paying compounded daily SOFR, with quarterly resets. At quarter end, if compounded SOFR averaged 4.22%, net inflow = (0.0435 - 0.0422) × $75M × 0.25 = $24,375. The daily compounding formula is product of (1 + SOFR_t × d_t/360) minus 1, where d_t is days to next business day. ```mermaid flowchart LR A[Fixed
Rate] --> B[Quarterly
Net] C[Compounded
SOFR] --> B B --> D[Settle
Cash] ``` OIS replaced LIBOR swaps because: 1. SOFR is based on actual repo transactions, not bank submissions, so it cannot be manipulated. 2. Overnight rates have minimal credit risk; forward OIS rates represent pure risk-free expectations. 3. Central counterparties use OIS rates to discount collateralized swap cash flows, making OIS the market's risk-free benchmark. Pricing uses the OIS curve directly. Dual-curve bootstrapping — OIS for discounting, LIBOR or SOFR term rates for forecasting — is now standard. Post-2022, SOFR term rates replaced LIBOR for most new USD business.

How does an OIS work and why has it replaced LIBOR swaps?

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