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Why OIS and LIBOR Curves Are Used to Value Bonds and Derivatives

Article Quant Q&A · Author: user3117403
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Summary

OIS and LIBOR swap curves are used to discount and compare bonds and interest rate derivatives because they better reflect the funding rates available to many financial institutions than US Treasury rates do. Treasury rates may be more appropriate when valuing an entity with credit quality comparable to the US government; for weaker borrowers, a higher discount rate may be warranted.

The notes also explain a portfolio-management reason: linking bonds to the curves used for swaps can make risk analysis more consistent across a book containing both bonds and interest rate derivatives. Treasury curves can be difficult to infer cleanly because individual bonds are affected by liquidity, specialness, and other bond-specific factors. These are general practitioner explanations; the appropriate curve still depends on the issuer, instrument, and valuation context.

Key ideas

  • OIS and LIBOR curves can represent funding rates more relevant to banks than Treasury rates.
  • Treasury discounting fits best when the valued issuer has government-like credit quality.
  • A higher credit risk generally calls for a higher discount rate.
  • Using swap curves for both bonds and swaps can support consistent portfolio risk analysis.
  • Treasury bond prices include liquidity and specialness effects that complicate curve construction.

Tags

Fixed incomeDerivatives pricingRisk management
Full text
# OIS & LIBOR swap


# OIS & LIBOR swap












Why do people use OIS and LIBOR swap spread to compare/value bonds/derivatives?

Why not just use US treasury?

## Answer by compilation-error (score 1)

https://quant.stackexchange.com/a/17077

Risk-free rate is used to discount future values to today; but we use this rate to denote cost of capital (loosely speaking) i.e., you can borrow/lend at this rate. US Treasuries would be used if the entity whose securities were being valued enjoyed the same credit as the government.

Since most banks can at best borrow at OIS/LIBOR; this becomes the rate of choice when valuing securities. As a side, if you wanted to value securities issued by a known bad credit, you would discount the future values more heavily using a rate higher than LIBOR/OIS.

## Answer by MattBecker82 (score 0)

https://quant.stackexchange.com/a/19483

In general, practitioners may run a combined book of Bonds and Interest Rate derivatives (Libor IRS, OIS etc.) In this case, in order to have an understanding of risk which includes all parts of the book in a systematic way, it makes sense to link the price of bonds to the LIBOR/OIS curves which underlie the valuation of interest rate derivatives.

Also there are some technical complexities when building a US treasury curve (or any bond curve for that matter) - individual bonds are driven by idiosyncratic factors (liquidity, specialness etc.) over and above the interest rate & credit default term structures. It can be difficult/impossible to isolate the different components that drive a bond's price and recover an idealised "pure" treasury-implied zero curve.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.