PorusMistry

Description

Porus Mistry ‘s Update : Overnight indexed Swap (OIS) – Concepts

“Pay Fixed” IRS (the user pays a fixed rate).

Corporate A borrowed at MIBOR +60 basis points from a Lender. Apprehensive that the MIBOR rate
would go up, and adversely affect his cost of funds, he enters into an OIS with a Bank / Institution. In
the deal Corporate A agrees to pay 9.05% fixed.

This means the Bank / Institution will pay Corporate A overnight MIBOR against which Corporate
A will pay the Bank / Institution a fixed rate of 9.05%. Note that now Corporate A is hedged
against any movement in MIBOR as whatever is the rate, he will receive the “rate” from the Bank /
Institution and pass it to the lender.

It should be remembered that the calculation are made on a daily compounding basis and the
settlement is netted and made at the end of the transaction.

Benefits of an OIS

Let us turn to the above example Corporate A has effectively hedged itself against any movements
in the MIBOR. The company has de-risked his liability book by entering into this transaction. After
entering into the OIS, Corporate A’s cost of funds in this transaction has been frozen at 9.05% (+)
0.60 = 9.65%. Note that the 60 bps is a sunk cost which Corporate A has to bear anyway.

Looking at the transaction from the perspective of Bank / Institution it might seem that it has
increased its risk by this transaction. This might not be the case. The Bank / Institution might have
had lent and created a Floating Rate asset in its books. In that portfolio it runs the risk that the
Floating Rate might fall and diminish its returns. By doing this transaction, the Bank / Institution has
effectively frozen its returns at 9.05% (ignoring whatever spread it might have earned on the asset).