An overnight index swap (OIS) is an over-the-counter derivative that allows two parties to exchange the cost of borrowing against a specific risk-free benchmark rate, usually based on a central bank rate such as the U.S. federal funds rate or the London Interbank Offered Rate (LIBOR).

Overnight index swaps resemble traditional interest rate swaps—where two parties exchange fixed and floating rate payments based on a notional principal amount—in that they involve an exchange of cash flows. The main difference is the length and type of rate used in the swap. OIS involve the overnight rate, while traditional interest rate swaps involve a rate fixed over a longer period of time.

In an overnight index swap, one party pays a fixed rate that is determined at the inception of the agreement, while the other party pays a floating rate based on the overnight rate. The interest of the overnight rate portion of the swap is compounded and paid at reset dates, with the fixed leg being accounted for in the swap's value to each party. The floating leg's present value (PV) is determined by either compounding of the overnight rate or by taking the geometric average of the rate over a given period.

The two parties involved in the swap must agree upon a notional principal amount, fixed rate, reset dates, and index and length of the rate used in the swap. Like other interest rate swaps, an interest rate curve must be produced to determine the present value of cash flows. The parties can also agree to reset dates and index money if the principal is not exchanged.

OIS are a popular hedging and financing instrument, as they provide participants solutions to reduce or manage the risk of interest rate fluctuations in the overnight markets. OIS are also used by asset managers and other financial institutions to lock-in a rate, or to gain access to liquid funds.

The flexibility of overnight index swaps make them attractive to sophisticated investors looking to manage their risk or increase returns. OIS are often used as part of asset-liability or interest rate risk management strategies, as well as a tool to manage liquidity, hedge other swap positions, or match the duration of an asset or liability.

Despite their flexibility, there is some degree of risk associated with overnight index swaps, as the rates and terms used in the swap may change over time. Additionally, the parties are exposed to counterparty risk, which means the risk that one of the parties fails to meet its obligation to the other.

In conclusion, OIS are flexible, relatively liquid derivative instruments used for hedging and financing purposes. They can be useful to sophisticated investors who understand the risks involved, but are perhaps more suitable for those more experienced with derivatives and how to manage the associated risks.