Fin-O-Pedia_Issue 30_Aug12-Aug18.pdf

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Top Stories: International

Know Your Basics:

A SIMSREE Finance Forum Initiative | Issue 30

FIN-O-PEDIA

et’s Talk FINANCE!!

SYDENHAM INSTITUTE OF MANAGEMENT STUDIES, RESEARCH &

ENTREPRENEURSHIP EDUCATION

2012

Know Your Basics:

Overnight Index Swaps

Letter Of Credit



Know Your Basics: Overnight Index Swaps

What is OIS?Overnight Index Swaps (OIS) are instruments that allow financial institutions to swap the

interest rates they are paying without having to refinance or change the terms of the

loans they have taken from other financial institutions. Typically, when two financial

institutions create an overnight index swap (OIS), one of the institutions is swapping an

overnight interest rate and the other institution is swapping a fixed short-term interest

rate. This may sound a bit strange, but here is how it works.

Imagine Institution #1 has a $10 million loan that it is paying interest on, and the interest

is calculated based on the overnight rate. Institution #2, on the other hand, has a $10

million loan that it is paying interest on, but the interest on this loan is based on a fixed,

short-term rate of 2 percent. As it turns out, Institution #1 would much rather be paying a

fixed interest rate on its loan, and Institution #2 would much rather be paying a variable

interest rate—based on the overnight rate—on its loan, but neither institution wants to

go out and get a new loan and they can’t renegotiate the terms of their current loans. In

this case, these two institutions could create an overnight index swap (OIS) with each

other.

To set up the swap, both institutions would agree to continue servicing their loans, but at

the end of a specified time period—one month, three months and so on—whoever ends

up paying less interest will make up the difference to the other institution. For example, if

Institution #1 ends up paying an average interest rate of 1.7 percent on its loan and

Institution #2 ends up paying an interest rate of 2 percent, Institution #1 will pay

Institution #2 the equivalent of 0.3 percent (2.0 – 1.7 = 0.3) because, according to their

agreement, they swapped interest rates. Of course, if Institution #1 ends up paying an

average interest rate of 2.2 percent on its loan and Institution #2 ends up paying an

interest rate of 2 percent, Institution #2 will pay Institution #1 the equivalent of 0.2

percent (2.2 – 2.0 = 0.2) because, according to their agreement, they swapped interest

rates.

The overnight index swap (OIS) market is quite large, and the movements in this market

can provide a lot of information for economists and analysts who are trying to understand

what is happening in the global financial markets. One of the key pieces of information



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analysts’ watch is the interest rate the institutions that have loans with variable interest

rates are paying.

The question is; how you determine what rate to use when each institution is paying a

slightly different rate based on what time of day they have to determine their payment.

You see, the overnight rate in constantly changing, and you will pay a different interest

rate at 6:00 am than you will pay at 11:00 am.

To resolve this issue, an overnight index swap rate is calculated each day. This rate is

based on the average interest rate institutions with loans based on the overnight rate

have paid for that day.

What Does the Overnight Index Swap Rate Tell Us?

By itself, the overnight index swap rate doesn’t tell us much—other than what the

overnight rate is. However, when you combine the overnight index swap rate with

another indicator, like LIBOR, and create a spread like the LIBOR OIS spread, you can get a

glimpse into the health of the global credit markets.



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Know Your Basics: Letter of Credit

What is LOC?

Banks issue letters of credit to ensure sellers that they will get paid as long as they fulfilconditions agreed upon.

Letters of credit are commonly used in international transactions because the bank acts as

a link between buyer and seller i.e. importers and exporters use letters of credit as a way

to protect themselves. It acts as a mode of communication between two parties. Issuing

bank may have a funding bank in country of exporter.

The bank will only issue a letter of credit after ensuring credibility of Importer from its

end. Some buyers have deposit enough to cover the letter of credit, and some customersuse a line of credit with the bank. Sellers must trust that the bank issuing the letter of

credit is legitimate.

Documentary Terms

Following terms are commonly used in L/C:

Applicant - the buyer in a transaction(Importer)

Beneficiary - the seller or ultimate recipient of funds(Exporter)

Issuing bank - the bank that promises to pay (Importer’s Bank)

Advising bank - helps the beneficiary use the letter of credit( Bank in exporter’s

country)

Payment Process

A seller only gets paid after performing specific actions that the buyer and seller agree to.

For example, the seller needs to deliver product or service to buyer in order to satisfy

requirements for the letter of credit. Once the merchandise/service is delivered, the seller

receives documentation proving about delivery. The letter of credit now must be paid

even if something happens to the merchandise. Seller will submit documents with Issuing

bank through advising bank. Documents represent ownership of goods.

To pay on a letter of credit, banks simply review documents proving that a seller

performed his required actions. They do not worry about the quality of goods or other

items that may be important to the buyer and seller.