In what way can an OIS swap reduce credit risk?

An Overnight Index Swap (OIS) can reduce credit risk primarily by allowing separate management of liquidity and credit risk. In an OIS, two parties exchange interest payments based on a notional principal amount, using an overnight rate as a benchmark. This structure means that payments are tied closely to short-term interest rates and can be settled regularly, allowing participants to manage their interest rate exposure without taking on significant credit risk associated with longer-term fixed-rate contracts.

Since OIS transactions are typically collateralized, the counterparty risk is reduced because collateral can be adjusted or posted as the market fluctuates. This enhances the creditworthiness of the swap positions as it mitigates the potential loss due to a default by one of the parties involved. The ability to manage liquidity independently from credit risk allows participants to optimize how they handle funds while securing against credit exposure, which is particularly useful in volatile market conditions.

In terms of the other choices, while guaranteed returns or immediate money transfer might sound appealing in theory, they do not accurately describe how OIS swaps operate in managing credit risk. Additionally, the involvement of only large institutional investors does not inherently reduce credit risk; rather, it focuses on the participants' profiles rather than the mechanism of how OIS swaps operate in mitigating credit