LIBOR vs. OIS: The Derivatives Discounting Dilemma
Abstract: Traditionally practitioners have used LIBOR and LIBOR-swap rates as proxies for risk-free rates when valuing derivatives. 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 for discounting when collateralized portfolios are valued and that LIBOR should be used for discounting when portfolios are not collateralized. This paper examines this practice and concludes that OIS rates should be used for discounting in all situations.
Keywords: LIBOR, OIS, Derivatives, Discounting.
Forthcoming in: Journal of Investment Management