Why Collateralized Swaps Are Discounted at Overnight Rates
Summary
The note distinguishes the credit exposure of an interest rate swap from the reason overnight rates are used for discounting. Its answer says that swaps referencing LIBOR or another floating rate generally have little counterparty risk when they are subject to daily margining, whether margin is exchanged directly or through an exchange. This collateralization limits the amount of uncollateralized exposure that builds up between counterparties.
The explanation links discounting to the remuneration on collateral: when posted margin earns a rate tied to fed funds, cash flows are commonly discounted using fed funds rates. Thus, the use of overnight rates is presented as a consequence of collateral terms rather than a claim that a swap has no credit risk or that its reference rate is intrinsically risk-free. The answer is brief and assumes daily margining and collateral remuneration; it does not compare specific collateral agreements, currencies, or market conventions.
Key ideas
- Daily margining keeps counterparty exposure on many interest rate swaps small.
- The floating rate referenced by a swap is distinct from the rate used to discount its cash flows.
- Discounting at fed funds is tied to the interest paid on collateral under the swap arrangement.
- Overnight discounting conventions depend on collateral and margin terms.
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# Why is the overnight index swaps considered risk-free? # Why is the overnight index swaps considered risk-free? What I have understood is that the overnight index swap is bootstrapped to discount rates/zero rates that in their turn are considered risk free. The reason being, that the reference rate of such swap - which is the overnight uncollateralized lending between banks - corresponds to overnight lending, which is close to risk-free due to its very short period. However, what I have also understood is that settlement of these overnight swaps are usually at maturity or annually for swaps longer than 1 year. The credit risk in such swap is thus actually the same as the credit risk in any LIBOR referencing swap due to the fact that settlement/maturity occurs further in the future, allowing for more counterparty credit risk. The only difference being the reference, that is, either LIBOR or the overnight rate. It thus means that in both cases there is an additional spread on both swap rates to adjust for the swap's credit risk. Now, one may argue that the credit risk in such swap is very small, however, the fact that we collateralize swaps, is to me, an indication that the credit risk is sufficiently significant. Are these observations correct? If they are, how good is the approximation of the overnight index swap really to risk-free? And if they are not, please correct me. ## Answer by dm63 (score 4, accepted) https://quant.stackexchange.com/a/30180 There's a lot of confusion here. Most Interest rate swaps (whether versus libor or another floating rate such as fed funds) have virtually no counterparty risk. That's because they are subject to daily margining, either with an exchange of directly between counterparties. The cash flows on these swaps are usually discounted at fed funds rates, because the interest paid on the margin amount is usually fed funds. It's nothing to do with the riskiness of the swap.
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