[PDF] LIBOR vs OIS: The Derivatives Discounting Dilemma

Should overnight indexed swap rates be used as risk-free rates?

This practice has been called into question by the credit crisis that started in 2007. Many banks now consider that overnight indexed swap (OIS) rates should be used as the risk-free rate when collateralized portfolios are valued and that LIBOR should be used for this purpose when portfolios are not collateralized.

What are swap rates?

For this reason, swap rates are sometimes referred to as “continually-refreshed” AA rates and are used to bootstrap the LIBOR curve. The resultant zero rates are those that are applicable to low-risk, but not zero-risk, expected cash flows.

Why do we use OIS rates for valuing 3 collateralized derivatives?

The reason often given for using OIS rates for valuing a 3 collateralized derivative is that the derivative is funded by the collateral and the federal funds rate (which, as we will explain, is linked to the OIS rate) is the interest rate most commonly paid on collateral.

How is the net value of a swap calculated?

The net value is calculated by taking the difference of the present value of the two legs of the swap. Since the bank sold this swap, they are the fixed leg payer. From the bank’s perspective, the value is the difference of the floating leg (asset) and the fixed leg (liability).