Why OIS Replaced LIBOR as a Derivatives Discounting Proxy

Summary

The document explains a change in the practical rate used to represent risk-free discounting in derivatives models. Before the financial crisis, LIBOR was commonly treated as a workable proxy because it stayed close to overnight indexed swap rates. After the LIBOR–OIS spread widened and became less stable, LIBOR no longer reliably represented that benchmark for discounting; banks generally moved to OIS-based modeling.

The central lesson is that a rate commonly used as a proxy can stop serving that role when credit and funding conditions cause it to diverge from a closer benchmark. The note is brief and does not derive a pricing framework, distinguish collateral agreements, or cover the transition away from LIBOR in detail. Its conclusion is a high-level historical account, so model implementation requires attention to the relevant currency, collateral terms, and market conventions.

Key ideas

• LIBOR was historically used as a practical proxy for risk-free discounting because it tracked OIS rates closely.
• The LIBOR–OIS spread widened and became unstable after the financial crisis.
• OIS rates became the more common basis for bank discounting models.
• The appropriate discount curve depends on market conventions and the pricing context.

Tags

# Risk Free Rate vs LIBOR


# Risk Free Rate vs LIBOR












Theoretically, in pricing derivatives, most textbooks refer to the risk-free rate. What is obtainable in practice? The risk-free rate or the LIBOR rate?

## Answer by SmallChess (score 2)

https://quant.stackexchange.com/a/28290

Before 2007, LIBOR was commonly used for risk-free rate. It was a good proxy because it was quite close to the OIS rates. Since 2007, the LIBOR–OIS spread has spiked and became unstable. Therefore, LIBOR is no longer a good proxy for discounting. Nowadays, Banks usually use OIS for modelling.

Read the wikipedia article on OIS-LIBOR spread. John Hull has a very popular paper on the subject.

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.