What is the difference between LIBOR and OIS as benchmarks in valuing interest rate swaps? Is LIBOR a risk free rate?
Few years back, the traders and especially the traders of the derivative instruments did not give much attention to the two important interest rates or the discount rates that are used for valuing the interest rate swaps or the derivatives in general. These two discount rates are Overnight Indexed Swap (OIS) and London Interbank Offered Rate (LIBOR). The reason for this is that before 2008, the spread or the gap between the two was minimal. However, after the financial crisis the LIBOR had skyrocketed and the financial sector of the world had taken an important note of this(PricewaterhouseCoopers, 2013).
The LIBOR and OIS is today considered as the key measure of the credit risk within the banking sector. In order to understand, why the variation in these two rates is important for the traders, it is highly important to understand the differences between LIBOR and OIS in valuing the interest rate swaps and derivatives in general(Mollenkamp, 2008). LIBOR is the average short term interest rate that is charged by the banks to one another to take out unsecured and short term loans. All the LIBOR rates for the different lending durations such as from overnight to a period of one year are published on the official websites on a daily basis. The interest rate charges that are charged by the banks on the financial products, credit cards, student loans and mortgages are tied to one of the LIBOR rates that are published.
Has Libor Lost Its Stature In Derivatives Market Harvard Case Solution & AnalysisQuestion 1
On the other hand, OIS is the FED fund rate and it is the key interest rate that is being controlled by the Federal Reserve. This rate is controlled over the course of the certain period(Brown, 2009). This is highly useful, for instance, if a corporation or any commercial bank wants to convert itself from the variable interest payments to the fixed interest payments or vice versa then it can swap the interest payments that are either fixed or variable with the counter party. For example, a UK based entity can exchange a floating or variable interest rate with a fixed rate that is the Fed funds effective rate (OIS).
When the LIBOR is used in the interest rate swaps such as in the vanilla swaps in which the fixed rate payments are exchanged for the floating rate payments based on LIBOR(John, 2014). On the other hand, the OIS is itself an interest rate swap where the floating interest payment at different periods are generally based on the return that is calculated on compound interest investment on a daily basis. The reference rate that is used for the daily compounding is based on the overnight rate. The actual or the final averaging formula would depend on the type of the rate that is being calculated(John, 2014). Therefore, we can clearly see that there are many fundamental differences of using LIBOR and OIS in the valuation of the interest rate swaps..................
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