OIS Discounting (risk-free) vs. LIBOR valuation
Since the financial crisis during 2007, the pricing of derivatives has been undergoing significant changes. Using the LIBOR rates for the discount curves did not seem sufficient anymore since the OIS-LIBOR spread widened considerably during the crisis and so did the EURIBOR-EONIA curve. For a long time, counterparties utilized bilateral collateral for over the-counter (“OTC”) derivative transactions for mitigating the credit risk of their counterparties. The funding advantages from collateral which can be rehypothecated possesses a value and it should be considered in derivative pricing (i.e. using the risk-free curve).
OIS Discounting uses the interbank overnight lending rates (for USD, Fed-Fund rates) for the curve construction. Maturities longer than two years can be constructed using the Swap rates on the market. For maturities longer than 15 years, market data for certain currencies is often difficult to construct. EONIA (EUR) and SONIA (GBP) rates can be derived from the Swaps which go out at 30 years. Beyond 10 years for the Fed-fund rates (USD) curve, the basis swaps have to be considered.
Starting from two to ten years, OIS swaps have yearly coupons and can be viewed similar to the fixed-float IRS where the index and discount curves are both the OIS (risk-free) curve.
Often, firms value uncollateralized transactions still using the the LIBOR curve. This is controversial since using LIBOR discounting will incorporate the counterparty risk twice, since it will be reflected in the CVA calculation.
The CSA (Credit Support Annex) has been widely used for posting collateral. The new CSA has been remodeled to reflect the risk free OIS discounting. The new standard CSA agrees on daily collateral postings. If these are failing, the transaction with that counterparty has to be be closed out. Due to these daily collateral postings, the risk-free discount rate can be applied on the new SCSA. This is referred to as “OIS discounting” or “CSA discounting”.
EURIBOR / LIBOR discounting
During pre-crisis, the discount curve was constructed using liquid instruments such as futures, FRAs and interest rate swaps.The EURIBOR rates are published at 11am daily and weighted average eliminating the top and bottom 15% from 40 contributing banks. 15 different maturities are published. Effective from 1st of July 2014 all LIBOR/EURIBOR rates had a licensing change.
EONIA rates / OIS Rates used for OIS discounting
The EONIA or Fedfunds rate is the interest rate which financial institutions use to move funds held at the Federal Reserve or at the European Central Bank among each other, usually based on an overnight terms. Financial institutions with excess funds in their accounts lend to other institutions in need. The weighted average of all these rate across among these transactions on a given day is the daily EONIA rate.
The related EONIA Swap Rate, which is used for the OIS discounting, is the fixed rate exchanged for a floating overnight rate.