Amortising OIS Hedge for a Floating-Rate Term Loan
An Indian auto-components manufacturer has a ₹500 crore working-capital term loan priced at six-month MIBOR plus 180 bps, reset every 15 January and 15 July. The loan amortises ₹50 crore on each reset date, beginning 15 July next year. On 1 April, six-month MIBOR is 6.40% and the treasury expects a sustained tightening cycle. The relationship bank quotes a three-year MIBOR-OIS at 6.85% and a five-year at 6.95%, both on a semi-annual, act/365 basis. The treasurer proposes paying fixed on a bullet ₹500 crore three-year OIS, arguing that it is simpler and more liquid than a matched-maturity amortising hedge. The CFO is worried about accounting treatment, the initial margin requirement, and whether the hedge will truly lock the loan's all-in cost. Company policy permits OTC derivatives only up to 100% of underlying exposure and requires a documented hedge-effectiveness test each quarter.
1. Should the treasurer hedge with a bullet ₹500 crore notional or an amortising schedule? Show the hedge-ratio logic and the consequence of each choice.
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The hedge should follow the principal outstanding. The loan starts at ₹500 crore and falls by ₹50 crore every six months, so the expected outstanding over the three-year hedge is roughly ₹350 crore on a simple average. A bullet ₹500 crore pay-fixed OIS leaves the company paying fixed on about ₹150 crore of notional with no floating loan behind it. If rates rise, that excess position makes money, but if rates fall it produces a speculative loss and may fail the hedge-effectiveness test. Use an amortising OIS with the same reset calendar and notional steps, or a series of forward-starting OIS tranches. The amortising hedge also reduces margin because initial margin is charged on notional, so the bullet ties up more collateral for the same economic exposure. The trade-off is liquidity: a tailored amortising OIS may be less liquid and costlier to unwind than a bullet, but for a ₹500 crore exposure the margin saving and cleaner accounting usually justify matching the amortisation.
2. What all-in borrowing cost does the three-year pay-fixed OIS approximately lock in, and what risks remain?
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Approximately 8.65%: the 6.85% OIS fixed rate plus the 180 bps spread, compared with 8.20% at the current 6.40% MIBOR. The lock is not exact. First, the loan sets six-month MIBOR at the start of each half-year, while MIBOR-OIS references overnight MIBOR compounded; a steep money-market curve creates tenor basis risk. Second, the 180 bps credit spread is not fixed by the OIS; if the lender reprices the spread, the all-in cost changes. Third, day-count and compounding conventions differ. Fourth, the OIS fixes the average overnight rate, not each six-month reset, so the timing of rate moves matters. The treasurer should compare the locked cost with the budgeted cost and disclose the residual basis risk. An OIS alone does not hedge the credit spread; a fixed-rate loan or a separate credit hedge would be needed for that.
3. The company cancels ₹100 crore of capex and will draw only ₹400 crore. What should it do with the hedge and why?
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It should reduce the hedge notional by ₹100 crore on the same amortisation profile, not leave the extra fixed position open. The OIS was designated against the loan; with less principal, the original hedge becomes overhedged and breaches the 100% underlying-exposure policy. Unwinding part of the OIS crystallises a gain or loss, but leaving it creates a speculative position that the board policy prohibits. The company should document the change in the forecast transaction, re-run the effectiveness test and check the counterparty's minimum notional and termination costs. If the cancellation timing is uncertain, it can use a forward-starting tranche or a partial unwind rather than a full tear-up. The key point is that hedge accounting and risk limits follow the exposure, not the original trade.