London Interbank offered Rate (libor) Case Analysis

Based on the group’s appreciation of the case, we are putting forward the following recommendations:

1. Overnight index swap (OIS) rates should replace the London interbank offered rate (LIBOR) as the reference rate for interest swaps
2. Consequently, we recommend that the $100 million notional principal swap with the period of nine months until maturity be valued using OIS rates

We would like to raise the following points to support our proposition:

1. OIS is a better measure for quantifying credit risk rather than LIBOR

Determining the value of a derivative requires in-depth consideration of credit risk and collateral agreements that involve such arrangements.^[1]  LIBOR, despite its widespread use prior to 2008, does not contribute much on the area of credit risk quantification. It is basically a crowd-sourced, consensus figure that captures a snapshot of the willingness of banks to lend funds amongst themselves as of a point in time. In fact, even if we consider these institutions as counterparties in a theoretical loan arrangement, LIBOR will be the result of the deliberations of the major banks’ top management that are driven by their current financial standing and liquidity positions. This element of the discount rate being affected by the bank’s funding costs assails this measure’s credibility for valuation (i.e. discounting) purposes. It cannot be overemphasized that discounting an investment using LIBOR would result to a valuation that does not reflect the financial instrument’s / business arrangement’s fair market value.

OIS, on the other hand, can capture the credit risk of an instrument (or loan arrangement) that is unblemished by risks that are inherent to the banks’ current conditions. As an investment should NOT be evaluated on how it is funded^[2] but on how it generates incremental returns over a reference risk-free rate (i.e. risk of investment) OIS acts as a better valuation factor for discounting as it removes the bank credit and liquidity risk that is incorporated in LIBOR.

2. Corollary to item no. 1, OIS is the best proxy for risk-free interest rates

In recent years, the use of collateralization in the interest rate swap market has become popular to nullify counterparty credit risk. During the 1990s, after the introduction of the Credit Support Annex (CSA) in the standard International Swap and Derivatives Association (ISDA) master agreement, it became a norm to post collateral in the form of market securities or cash. Nowadays, bilateral CSAs with zero thresholds are common in the market. These CSAs only require the counterparty which has a credit risk to post collateral. Thus, because of these developments, credit risk on swaps has become very low, due to which the discount factors used to price these swaps needs to be based on (near) risk-free interest rates.^[3]