What is a 24-hour index exchange?
An index swap refers to a hedging contract in which a party exchanges a predetermined cash flow with a counterparty on a specified date. Debt, stocks or some other price index is used as an agreed exchange for one side of this swap. A day-to-day index exchange applies an overnight rate index like federal funds or Libor rates. Index swaps are specialized groups of conventional fixed rate swaps, the terms of which can be defined from three months to more than one year.
Key points to remember
- The interest on the overnight rate swap portion is compounded and paid on reset dates, the fixed leg being recognized in the value of the swap for each party.
- The current value of the floating leg is determined either by composing the overnight rate or by taking the geometric average of the rate over a given period.
- As with other interest rate swaps, an interest rate curve must be produced to determine the present value of cash flows.
How does an index exchange work overnight?
Overnight index swap means an interest rate swap involving the exchange of the overnight rate for a fixed interest rate. A day-to-day index exchange uses an overnight rate index such as the federal funds rate as the underlying rate for the floating leg, while the fixed leg would be set at a rate agreed to by both parties. .
Overnight index swaps are popular among financial institutions because the overnight index is considered a good indicator of the interbank credit markets and less risky than traditional interest rate spreads.
How to calculate an index exchange overnight
Nine steps are applied in calculating the dollar advantage of a bank using a daily index swap.
The first step multiplies the overnight rate for the period during which the swap applies. If the swap starts on a Friday, the swap period is three days because transactions are not settled on weekends. If the swap begins on another business day, the swap period is one day. For example, if the overnight rate is 0.005% and the swap is made on a Friday, the effective rate would be 0.015% (0.005% x 3 days), otherwise it is 0.005%.
The second step in the calculation divides the effective overnight rate by 360. Industry practice requires that overnight swap calculations use 360 days for a year instead of 365. Using the above rate , the calculation in step two is as follows: 0.005% / 360 = 1.3889 x 10 ^ -5.
For step three, simply add one to this result: 1.3889 x 10 ^ -5 + 1 = 1.00003889.
In step four, multiply the new rate by the total principal amount of the loan. For example, if the overnight loan has principal of $ 1 million, the resulting calculation is as follows: 1.00003889 x $ 1,000,000 = $ 1,000,013.89.
The fifth step applies the above calculations to each day of the loan, the principal being constantly updated. This is done for multi-day loans in case the rate varies.
Steps six and seven are similar to steps two and three. The rate used by overnight index swaps should be divided by 360 and added to 1. For example, if this rate is 0.0053%, the result is: 0.0053% / 360 + 1 = 1 , 00001472.
In step 8, increase this rate by the power of the number of days in the loan and multiply by the principal: 1.00001472 ^ 1 x $ 1,000,000 = $ 1,000,014.72.
Finally, subtract the two amounts to identify the profit made by the bank with the swap: $ 1,000,014.72 – $ 1,000,013.89 = $ 0.83.