Valuing Interest Rate Swaps Using
Overnight Indexed Swap (OIS) Discounting

Abstract

The role of LIBOR in interest rate swaps and other financial derivatives is to be the effective “riskless” rate, based on the premise that while banks that could borrow in the market at LIBOR flat were not completely risk-free, the rate corresponded to a high credit quality, approximately AA. The 2008 financial crisis left most banks financial weakened, including the largest banks, which provide the quotes from which LIBOR is computed. LIBOR spiked upward following the Lehman bankruptcy and was well above other “riskless” rates, notably the overnight indexed swap (OIS) rate. Since that time, much of the over-the-counter (OTC) interest rate derivatives market has shifted over to discounting at OIS rates. Since these are lower than LIBOR, one result is that when the floating leg of a LIBOR-based swap is repriced, it will not be valued at par with OIS discounting. This issue is becoming increasingly important, as swaps and other interest rate derivatives are transitioning to central clearing. In this article, Smith clarifies the issues and works through some examples to illustrate the size of the effects involved.

TOPICS: Interest-rate and currency swaps, financial crises and financial market history