Guys, I'm just starting a pricing class and am a little confused by a statement in a class reading (a fed report). It goes something like this:
"A bank borrowing at the 3-month LIBOR rate of 2.10
percent that enters into a swap to receive at the 3-month OIS
rate of 2 percent has a borrowing cost equal to the effective
federal funds rate plus 10 basis points."
I'm not sure how does the fed funds rate come into the picture here. Is it assumed that the bank initially borrows the principal at fed funds rate and now has to pay a net 10 bps interest in this swap deal which adds up to a total effective borrowing cost of fed funds rate + 10 bps?
Could someone please clarify? Any input would be appreciated.
Thanks in advance.
Basically (let's avoid the really gory details for the sake of simplicity), it's like this: Leg 1: bank pays 2.1% Leg 2: bank receives 2% Leg 3: bank pays daily FF effective
Legs 2 & 3 together comprise the FF OIS swap. Legs 1 & 2 net out to 10bps, et voila.
Thanks a lot Martinghoul, that was very helpful! Just to clarify, the rate on leg 2 (the fixed 2%) in the FF OIS swap is effectively the OIS rate, is that correct?
Leg 2 is the fixed rate leg of the FF OIS swap. 2% is a rate that makes the receiver indifferent to which leg of FF OIS transaction they would prefer.
Got it. So when people are referring to the so called OIS rate, they are talking about that number which is either the fixed leg rate or the FF rate since they would have the same value when people initially enter into a OIS deal. (which also implies that swap itself would have zero value at T0). Would that be an appropriate way to understand this? Thanks!
Yes, more or less correct...
Thank you! I know my questions are really really basic, but I just get started and wouldn't want to miss a thing:)
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