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OIS Contracts And How They Help Your Trading
A quick question here from Kerin who asks, “Please elaborate on OIS contract prices. Why are we using them to track interest rates and what is OIS?”
So OIS stands for Overnight Index Swap. And an Overnight Index Swap contract is a contract which allows one party with a fixed interest rate to swap that with a party with a floating interest rate.
Now, the floating interest rate in this OIS contract is derived from an overnight rate index, such as LIBOR in the UK, Euribor in Europe or the Effective Fed Funds Rate in the US. So what happens is the overnight index, which the OIS contract derives its value from, well, that price adjusts with market expectations. So the OIS reflects the average interest rate which was charged overnight.
So what this means is we can use OIS contracts to essentially gauge how the markets’ outlook on interest rates is changing over time. So in other words, they allow us to predict what the market expects to happen to interest rates in the future.
Now, of course, there are many alternatives to OIS prices to predict how central banks are expected to adjust interest rates but the nice thing about OIS prices and why we focus on OIS prices is because they’re readily available for all of our major currencies and also, it’s a very consistent approach.
So whereas, if you look at different forms of futures contracts, such as Fed Fund Futures, essentially, all these different futures contracts have different underlying calculations to convert them into a probability for future rate hikes or future rate cuts, depending on what the market is expecting. So by using OIS prices, we get a much more consistent approach for all of our major central banks.
Now, another nice thing about OIS prices is we can actually take OIS contracts from different periods of time and we can use that to determine how the market expects interest rates to adjust over a given time period.
So for example, looking on our interest rate probability tracker, when you expand from beyond just the upcoming meeting, you’ll see we actually have the calculated expectations over a 12-month horizon and then we can actually display the Overnight Index Swap curve so we can see exactly how the market expects interest rates to adjust over time. In this case, over a 12-month period. \
So this is why we use OIS prices, this is why they are very insightful into determining what central banks are expected to do in the future, and of course, that’s key to a currency’s fundamental outlook as it allows us to determine how monetary policy is expected to adjust.