The financial crisis of 2007-09 precipitated a significant change in the methodology for interest rate swap valuation. Before the crisis, market practice was to use discount rates based on LIBOR (London Interbank Offered Rate) swaps to determine the market value of a standard fixed-for-floating interest rate swap. Because swaps are typically collateralized in accordance with the Credit Support Annex to the standard ISDA (International Swap and Derivatives Association) master agreement, they present minimal credit risk. LIBOR was deemed to be a reasonable and workable proxy for “risk-free” interbank interest rates.
That fixed rates on overnight indexed swaps (OIS) were in principle a closer representation of the “risk-free” yield curve did not matter in those days. Prior to the financial crisis, the LIBOR-OIS spread was not significant, staying between five to 10 basis points. In addition, using LIBOR discounting for interest rate swap valuation had been done since the inception of the market in the 1980s. That is what was programmed into back office accounting systems and that is what people knew.
Starting in the summer of 2007, the LIBOR-OIS spread jumped up dramatically, averaging 50-100 basis points and spiking up to 350 at the time of the Lehman bankruptcy. It later subsided, only to increase again owing to concerns about Euro-zone banks. Currently, it has been running about 40 basis points.
Given the significant and persistent LIBOR-OIS spread, LIBOR has lost its status as a proxy for interbank “risk-free” interest rates. The derivatives clearinghouses have formalized the transition to OIS discounting—that is what they have started to use to determine collateral requirements. There have been winners and losers in this transition. Because interest rates have trended down in recent years, counterparties receiving the fixed rate leg to the standard swap benefit by the switch to discounting using the lower OIS rates. Losers include those counterparties paying the fixed rate as the market value of their liability is calculated using lower discount rates.
When I wrote the interest rate swap chapter to Bond Math: The Theory Behind the Formulas in 2010, I covered only standard LIBOR valuation. Frankly, it usually takes a couple of years before events in the real world to percolate up to those of us who live in ivory towers. Fortunately, a couple of friends who have real jobs alerted me last year to the growing practice of using OIS rates to value collateralized swaps. I wrote a tutorial this past semester for my MBA students to update chapter eight in “Bond Math”. It can be downloaded at http://management.bu.edu/files/2011/10/A-Teaching-Note-on-Pricing-and-Valuing-Interest-Rate-Swaps-with-LIBOR-and-OIS-Discounting-1.pdf
Donald J. Smith, Ph.D., is an Associate Professor of Finance and Economic at the School of Management, Boston University, where he teaches graduate-level courses on fixed income markets, as well as executive education courses and author of Bond Math: The Theory Behind the Formulas. Professor Smith also consults to commercial and investment banks, financial firms, and law firms. He has written numerous articles for various academic and professional journals.