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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.

Vol_Smile
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1 Answers1

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Vol_smile. The sentence as you quote it doesn't make much sense, but my guess as to what they mean is this:

OIS stands for Overnight Index Swap. In the US the overnight rate is called Fed Funds as 'experequite' mentioned (in the Euro-zone it is Eonia). The bank is borrowing at 3m Libor, which in this example is currently 2.10%. If 3m Fed Funds OIS is at 2%, then the bank is borrowing 10bps above 3m Fed Funds OIS (2.1% - 2%). If the bank then doesn't want to have any dependency on Libor they could enter a 3m swap in which they receive Libor and pay Fed Funds + X bps. since this swap will have 0 PV at the moment of execution (otherwise either they or the counterpart wouldn't do it) X = 10bps.

Hope that helps. Must be quite an old report if 3m Libor is 2.1%. Wonder how long it'll be till we see those rates again.

Rostock
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