Difference between OIS Rate and Fed Funds Rate
I understand Fed Funds Rate is the rate at which banks lend/borrow to/from each other to maintain their daily reserve requirements at the Central Bank; also it is unsecured-meaning no collateral.
Is this the same as the OIS rate? I read somewhere that this effectively the same as the Fed Fund Rate- however, OIS is supposed to be secured lending rate, unlike Fed Funds rate. So, how can they be the same, or even similar?
The OIS is not the secured (collateralised) lending rate. It represents the cost of repeated overnight unsecured lending over periods of up to two weeks (sometimes more). Because it is based on overnight lending, it is assumed to have a lower credit risk than longer term interbank loans based on say 1M, 2M or 3M Libor and this is what drivers the OIS-Libor spread.
An overnight index swap (OIS) is a swap in which one party pays a fixed rate of interest known as the OIS rate which depends on the term of the swap and is known at trade inception. It is linked to the cost of unsecured lending.
The other party pays the rate equivalent to the daily compounded index rate over the life time of the OIS. This is not known until the end of the life of the OIS.
To make the OIS swap have zero initial value at inception, which is how it is traded, the OIS rate therefore must equal the market's expectation of what the compounded daily (geometric average) index rate will be over the lifetime of the OIS.
In USD the index rate is the fed funds rate which is linked to the cost of unsecured lending. In Euros the unsecured lending rate to which the OIS is linked is EONIA and in Sterling it is called SONIA where ONIA stands for overnight index rate.
The main use of OIS swaps is to allow banks to lock in the cost of unsecured overnight funding in advance.
Finally, your confusion may be due to the use of OIS for discounting of collateralised non-cleared derivatives. This is market practice since 2008. The OIS rate is used because it is close to the typical interest rate paid on the collateral that is held. It becomes the best estimate of the risk-neutral risk-free rate in a world where the collateral has effectively eliminated counterparty risk.
Secured and unsecured refers to lending. However OIS is a swap based on FF, not a loan. It is a different animal. So OIS is a derivative, or a bet, based on the average of future (unsecured) FF rates over a period..
For example my name is Noob Rademayer, I am not a bank so I can't lend or borrow FF in the interbank market, but I can bet on the rate at which banks do. (For example I could bet that the cost of borrowing 1,000,000 in FF over the next 30 days will go up). To let me make these bets the counterparty may require me to put up a small amount of margin, however I still would not call that secured lending, it is just the normal margin for any derivative trade nowadays (enough to cover the loss if something goes wrong, maybe 1000 USD, not the full notional). On the other hand if I wanted to borrow 1 million USD from my broker I would have to put up more than 1 million in marketable securities; that is a secured loan.
The fixed leg of the OIS is an unsecured rate that is very close to Risk Free Rate (RFR) because of the combination of several reasons:
it is akin to a money market term deposit rate swapped against overnight deposit rates, compounded geometrically over the swap lifespan, so a net expected present value at inception of zero (Feynman-Kac) should reflect overnights lending rates levels (e.g. EFFR, OBFR, SOFR, EONIA, SOFIA), averaged over the swap lifespan
there is no exchange of principal, therefore the accrued exposure is minimal
settlement of an OIS is at termination, and
in a swap, the counter party risk is the replacement cost