Short-Term Overnight Indexed Swaps Can Help Predict Monetary Policy, RBI Study Finds

Overnight indexed swap rates provide a credible way to measure the market's expectations of the future path of the repo rate, according to a research by the Indian central bank.

Overnight indexed swap rates for tenors of up to one year—specifically 1, 9 and 12 months—on average approximate the market's expectation of future short-term interest rates, according the study published in the Reserve Bank of India's monthly bulletin for February.

An overnight indexed swap is a derivative contract where the counterparties agree to exchange a fixed interest rate payment for a floating rate payment computed on a notional principal amount during the tenor of the contract. Such swaps, the RBI said, are gaining popularity among financial market-based measures to assess interest rate expectations.

For the study, the RBI computed returns for various tenors of OIS rates, from 1-month to 10 years, from August 3, 1999 to May 31, 2019.

One possible reason for the 9- and 12-month OIS rates emerging as a more accurate measure of future short-term interest rates could be that the market is able to predict the direction of monetary policy but not exact timing, the authors of the study explained.

For instance, a market expectation of a rate hike of 25 basis points in two months may materialise only after six months. Such a scenario may lead to actual excess returns for 3- and 6-month OIS transactions turning non-zero, while that for the longer tenor 9- and 12-month contracts may not be affected to that extent. Thus, it could be said, that OIS rates are a better predictor of the direction of monetary policy rather than the actual timing of the policy action.

To be sure, the indicator can only provide a credible measure of market expectations in normal times. Unanticipated changes in monetary policy during 2008 and 2013 in the wake of the global financial crisis and the ‘taper tantrum' significantly impacted ‘excess returns' in the OIS market, the study found.