Electronic copy available at: http://ssrn.

com/abstract=2036979

BostonUniversitySchoolofManagementResearchPaperSeries
No.2012-11

ValuingInterestRateSwapsUsingOISDiscounting

DonaldJ.Smith

Electronic copy available at: http://ssrn.com/abstract=2036979

Valuing Interest Rate Swaps Using OIS Discounting




March 2012





Donald J. Smith
Associate Professor of Finance
Boston University School of Management
595 Commonwealth Avenue
Boston, MA 02215

Phone: 617-353-2037
Email: donsmith@bu.edu

Electronic copy available at: http://ssrn.com/abstract=2036979

1

Valuing Interest Rate Swaps Using OIS Discounting
The financial crisis of 2007-09 precipitated a significant change in the practice of
interest rate swap valuation. Going from traditional LIBOR to OIS (overnight indexed
swap) discounting might not seem to be a profound event but it is more than just another
method to calculate fair values for over-the-counter derivative contracts. It embodies
newfound appreciation of counterparty credit risk and the role of collateral and central
clearing. Implementation of OIS discounting has created a cottage industry for risk
management consultants and trainers to deal with the technicalities of the new approach.
From my academic perspective, it is clear that many of our finance textbooks that cover
interest rate swaps need to be revised.
The first section of this note reviews interest rate swap valuation in principle, the
reasons for the move from LIBOR to OIS discounting, the implications for swap rates,
and the winners and losers that arise from the transition. The second section works
through a numerical example to illustrate the calculations. This entails bootstrapping a
sequence of discount factors that are consistent with interest rate swaps that have a
market value of zero. The implied LIBOR forward curve is derived (or, in general, the
forward curve for the money market reference rate). This curve becomes particularly
important under OIS discounting when valuing a swap as a combination of fixed-rate and
floating-rate bonds.
Fortunately for risk managers, OIS discounting uses the same types of analytic
techniques as the traditional approach. However, there are some differences that are
beyond the scope of this note, for instance, calculating the sensitivities of swap values to
changes in OIS rates and the LIBOR-OIS spread (i.e., working with dual curves rather

2

than a single curve for risk measurement) and dealing with cross-currency swaps. Also,
LIBOR is an interest rate that reasonably can be assumed to vary day by day in the
interbank market whereas OIS rates are more directly a tool of monetary policy,
suggesting that rate volatility depends on the pattern and timing of policy meetings and
actions.
1

Interest Rate Swap Valuation in Principle
An interest rate swap can be interpreted as: (1) a series of forward contracts on the
reference rate, and (2) a long/short combination of a fixed-rate and a floating-rate bond.
2

Consider a 2-year, USD 100 million notional principal, 5.26% fixed-rate, quarterly
settlement swap on 3-month LIBOR, as illustrated in Exhibit A. In the first interpretation,
the swap is a package of eight implicit forward rate agreements (FRAs), each exchanging
3-month LIBOR for a fixed rate of 5.26%. The counterparties to the series of FRAs are
the fixed-rate receiver on the swap (the receiver) and the fixed-rate payer (the payer).
In the second interpretation, the receiver has a long position in an implicit 2-year, 5.26%
quarterly payment bond and a short position in an implicit 2-year floating-rate note
(FRN) paying 3-month LIBOR with quarterly resets. The payer has the opposite bond
positions.
If this swap currently has a market value of zero, it is described as being at-
market or at par. Actual FRAs on 3-month LIBOR have a different fixed rate for each
future time period, reflecting the shape of the underlying forward curve. Unless that
curve is remarkably flat, the swap is a package of off-market FRAs because each has
the same fixed rate of 5.26%. However, the market values of the FRAs sum to zero. That

3

describes how the fixed rate on an at-market swap is determined at inception: It is set so
that the implicit FRAs, some of which have positive values and others negative values,
net to zero. In the bond interpretation, the implicit fixed-rate bond has a coupon rate set
so that its price matches that of the FRN paying 3-month LIBOR.
The upper panel of Exhibit B displays the balance sheets for the two
counterparties. The at-market swap having a value of zero is not shownit is off-
balance sheet or, one can say, it is hidden on the line dividing assets from liabilities. The
only accounting item shown is OCI (other comprehensive income), a portion of
shareholders equity that is used to register changes in the value of derivative contracts.
Now suppose that time passes and market interest rates change. The middle panel shows
the balance sheets if swap market rates fall. The derivative appears as an asset to the
fixed-rate receiverit has migrated off the lineand as a liability to the payer. The
offsetting accounting items are increases and decreases in OCI. The lower panel shows
results if instead swap rates rise. The accounting rules for derivatives (e.g, SFAS 133 and
IAS 39) determine whether the changes in swap values also need to flow through the
income statement before impacting OCI.
The methods to value an interest rate swap and to determine the size of boxes in
Exhibit B follow from the two interpretations. In the first, the exposure to the eight
implicit FRAs can be hedged by entering a mirror swap, thereby eliminating the risk of
further volatility in LIBOR. Suppose that the fixed rate on a 2-year, quarterly settlement,
at-market swap is 3.40% and that the 5.26% now off-market swap was entered several
years ago and currently has two years remaining. Rates have fallen (or, possibly, the
swap has just slid down a stable but steeply and upwardly sloped yield curve), as in the

4

middle panel. The fixed-rate receiver can enter, in principle, a pay-fixed mirror swap to
lock in the value of its asset; the payer can enter a receiver swap to stanch further losses.
This establishes a sequence of eight quarterly payments on the order of USD 465,000,
depending on the day-count convention and neglecting the bid-offer spread, flowing from
the payer to the receiver: (5.26% 3.40%) * 100,000,000 * 0.25 = 465,000. The swap
valuation problem is to calculate the present value of this annuity.
In the combination-of-bonds interpretation, the value of the swap is driven by
changes in the implicit fixed-rate bond. As rates are assumed to have fallen, the 5.26%
fixed-rate bond is priced at a premium above par value. By design, an FRN has limited
price volatility. Said differently, its duration is low and often is figured to be the time
until the next rate reset date. Using this interpretation, the duration of the swap can
calculated as the difference in the durations of the two implicit bonds. A receiver swap
has a positive duration statistic. A payer swap in turn has negative duration, meaning its
market value is positively correlated to rates, as shown in the lower panel of Exhibit B.
The value of the swap is the premium price on the fixed-rate bond less the value of the
FRN, which typically is assumed to be par value on a reset date.
The key point is that swap valuation is all about discounting future cash flows.
The traditional approach has been to use discount factors that correspond to the reference
rate on the swap, e.g., 3-month LIBOR. That is a much stronger assumption that it might
seem. If the swap is not collateralized, it implies that the counterparty for which the swap
is a liability, here the fixed-rate payer, has credit quality consistent with the banks that
establish the LIBOR index. Presumably, this counterparty can borrow funds for two years
at LIBOR flat (meaning a margin of zero above or below the reference rate) on a

5

quarterly payment floating-rate basis or at 3.40% fixed. In sum, the LIBOR discount
factors are appropriate to get the present value of its unsecured future obligations.
Usually, this corresponds to an investment-grade borrower having a quality rating of A+
to AA on its debt.
Suppose instead that the fixed-rate payer is a financially distressed company that
has had its credit rating lowered to non-investment grade. If the fixed-rate receiver
requested early termination of the swap, the payer would offer to settle the obligation for
an amount that reflects its cost of borrowed funds and not that of an investment-grade
issuer. While using default-risk-adjusted discount factors is appropriate in principle for an
early termination, it would be unwieldy for routine valuations carried out daily by swap
dealers having a multitude of open contracts.
The advantage to using the LIBOR swap curve is that there are good data
publically available for a full range of maturities. Importantly, the bootstrapped numbers
are internal to the valuation problem. In this traditional approach, the fixed rates on at-
market swaps (or the prices on 2-year fixed-rate bonds and FRNs having comparable
credit risk) can be used to bootstrap the discount factors needed to value the swap book.
Those calculations are demonstrated in the next section.
An important development in the interest rate swap market in recent years has
been widespread use of collateralization to mitigate counterparty credit risk. When the
market started in the 1980s, most swap contracts were unsecured and any imbalance in
the credit standings between the two counterparties was priced into the fixed rate or
managed by having the weaker party get some type of credit enhancement. In the 1990s,
after the introduction of the CSA (Credit Support Annex) to the standard ISDA

6

(International Swap and Derivatives Association) master agreement, posting collateral in
the form of cash or marketable securities became more common. Nowadays, bilateral
CSAs with a zero threshold, meaning only the counterparty for which the swap has
negative value posts collateral, is the industry norm. The specific terms of the CSA in the
ISDA document are complex and go beyond the scope of this note.
Johannes and Sundaresan (2009) contend that the fixed rate on a collateralized
swap should be higher than when it is uncollateralized and provide empirical evidence to
support that finding. The reasoning is similar to the convexity adjustment between
interest rates on exchange-traded futures and over-the-counter forwards. The idea is that
posting collateral is costly to the counterparty for which the swap is underwater,
meaning having a negative market value. Either the funds or the securities to satisfy the
collateral requirement need to be borrowed or are diverted from other uses.
The reason for the higher fixed rate on a collateralized swap is that the impact of
having to post costly collateral is not symmetric to the counterpartiesthe fixed-rate
receiver suffers from interest rate volatility while the payer benefits. Suppose the swap is
underwater to the receiver because swap rates have risen since inception. If rates rise
further, more costly collateral is needed; if rates fall, less is required. In contrast, suppose
the swap is underwater to the payer because rates have fallen. If rates then rise, less
collateral is needed; and if rates fall further, more is required. Systematically, the fixed-
rate receiver posts more costly collateral when interest rates go up; the payer posts more
when rates do down. This asymmetry, other things being equal, leads to a higher fixed
rate on the collateralized swap.

7

The main implication of collateralization is that the credit risk on the swap
becomes minimal, similar to exchange-traded futures contracts. To be sure, futures entail
initial margin accounts by both counterparties to provide an additional buffer, whereas
bilateral CSAs have a zero threshold so there still is some tail risk. In any case,
minimal credit risk means that the discount factors to get the present value of the annuity
for the difference between the contractual and at-market fixed rates (or to value the
implicit bonds) should be based on (near) risk-free interest rates.
Why then is it not market practice to use actively traded U.S. Treasury notes and
bonds, for which there are ample price data, to get the discount factors to value USD-
denominated derivatives that are nearly risk-free? The problem with Treasury yields is
that typically they are too low for this purpose. Treasuries are by far the most liquid debt
security and are in high demand as collateral in the repo market. Exemption from state
and local income taxes lowers their yields even more. Also, Treasury yields are more
volatile than swap rates because they are the first asset class to absorb fluctuations in
demand and supply arising from international capital flows, especially during flights to
quality.
The ideal discount factors to value collateralized contracts would come from
traded securities having the same liquidity, tax status, and volatility as the interest rate
swaps but credit risk approaching zero. Pre-2007, dealers as well as their regulators and
auditors viewed fixed rates on LIBOR swaps to be a reasonable and workable proxy for
the risk-free yield curve. However, in the post-2007 world the presence of a persistent
and sizable LIBOR-OIS spread exposes the credit risk approaching zero presumption.

8

An overnight indexed swap is a derivative contract on the total return of a
reference rate that is compounded daily over a set time period. In the U.S. dollar market,
the reference rate is the effective federal funds rate. It is calculated and released by the
Federal Reserve each day in its H.15 Report and is the weighted average of brokered
trades between banks for overnight ownership of deposits at the Fed (i.e., bank reserves).
The effective fed funds rate is not necessarily equal to the target rate set by the Federal
Open Market Committee (FOMC) and announced at regularly scheduled FOMC
meetings. The Fed merely aims to keep the effective rate close to its target via open
market operations of buying and selling securities. In the Euro-zone, the OIS reference
rate is EONIA (Euro Overnight Index Average, which essentially is the 1-day interbank
rate. In the U.K., the reference rate is SONIA (Sterling Overnight Index Average).
Until August 2007, the LIBOR-OIS spread was consistently narrow, typically just
5-10 basis points, thereby justifying the use of LIBOR discount factors to value
collateralized swaps. Some commentators date the onset of the financial crisis at August
9, 2007, which was the day when the LIBOR-OIS spread first spiked upward. It remained
high, oscillating between 50 and 100 basis points, and then jumped again in the fall of
2008, reaching its pinnacle at about 350 basis points after the announcement of the
Lehman bankruptcy on September 15, 2008. It then returned to more normal levels in
2009 only to go up again in 2011 reflecting concerns over the Euro-zone sovereign debt
crisis. A similar pattern appears in EURIBOR-EONIA spreads.
The OIS curve is now preferred by dealers to value collateralized interest rate
swaps because it removes the bank credit and liquidity risk that is being priced into
LIBOR. OIS rates, unlike LIBOR, now represent risk-free rates for banks and satisfy the

9

credit risk approaching zero criterion. Moreover, the Dodd-Frank Act of 2010
mandates that U.S. dealers use central clearing for standardized swaps and
collateralization for un-cleared transactions. In response, central clearers such the
CMEGroup and the London Clearinghouse, LCH.Clearnet, specifically use OIS
discounting to value interest rate swaps and to determine collateral requirements.
In general, fixed-rate receivers gain and payers lose following the switch from
LIBOR to OIS discounting when the swap yield curve is upward sloping and the LIBOR-
OIS spread is positive. Nashikkar (2011) points out that this could impact end-users who
have a large directional book, meaning they typically enter the same type of swap. For
example, life insurance companies and defined-benefit pension funds enter receive-fixed
swaps to reduce the duration mismatch between their assets, which are mostly equity and
corporate bonds, and their long-term liabilities. On the other hand, the GSEs
(Government-Sponsored Enterprises) like Fannie Mae and Freddie Mac tend to enter
pay-fixed swaps to hedge their positions in long-term fixed-rate mortgages. Other
impacts are on hedging strategies for swap dealers and end-users because the switch
introduces exposure to the LIBOR-OIS spread, on the pricing of other derivatives
because the implied LIBOR forward curve changes, and on possible implications for the
accounting for interest rate swaps (e.g., whether the swap qualifies for hedge accounting
treatment).

Interest Rate Swap Valuation in Practice
A numerical example is instructive to explore some of the nuances of swap
valuation using LIBOR and OIS discount factors.
3
Consider again a 2-year, USD 100

10

million notional principal, 5.26% fixed versus 3-month LIBOR, quarterly settlement
swap at a time when the otherwise comparable at-market fixed rate is 3.40%. A cursory
value of USD 3,581,649 is obtained by discounting the 8-period annuity of USD 465,000
using the at-market fixed rate and neglecting the actual day-count convention:


465,000
j
(1+ 0.0340/ 4)
= 3,581,649
j=1
8

This calculation assumes a flat swap curve because each payment is discounted by the
same interest rate. In general, LIBOR discount factors for the full term structure are used
to integrate the shape of the swap curve, which typically is upward sloping.
The traditional valuation method uses cash market rates for LIBOR for the first 12
months and then at-market swap fixed rates beyond that. For this numerical exercise,
assume these observations for LIBOR deposits: 3-month, 0.50%; 6-month, 1.00%; 9-
month LIBOR, 1.60%; 12-month, 2.10%. In the USD market, the actual/360 day-count
convention and simple interest are used to determine cash flows. For 92 days in the first
3-month time period (n = 1), for instance, from March 15
th
to June 15
th
, the LIBOR
discount factor is:


1
LIBOR
DF
=
1
1+ 0.0050*92/ 360 ( )
= 0.998724
For 92 days in the second quarter (n = 2) between June 15
th
and September 15
th
,

2
LIBOR
DF
is:


2
LIBOR
DF
=
1
1+ 0.0100*184 / 360 ( )
= 0.994915
Calculated in the same manner,

3
LIBOR
DF
for 275 days is 0.987925, and

4
LIBOR
DF
for
365 days is 0.979152. To generalize, quarterly LIBOR discount factors based on money

11

market rates are determined with this formula in which A
j
is the fraction of the year for
the j
th
period given the particular day-count convention (i.e., actual/360, actual/365,
30/360):

( ) +
=
=
n
j n j
LIBOR
n
A LIBOR
DF
1

* 1
1
, n = 1 to 4 (1)
For this exercise, quarterly discount factors suffice; in practice, daily discount factors are
needed to value the entire swap book.
Beyond 12 months, discount factors are calculated by bootstrapping fixed rates on
at-market swaps. Typically, these quoted rates start at a tenor of two years. That creates a
problem for the risk manager and the need to interpolate for the span between year one
and year two. That often leads to a jump or a kink in the LIBOR forward curve and
discount factors. This example finesses that problem by assuming that at-market (or par)
swap fixed rates are: 15-month, 2.44%; 18-month, 2.76%; 21-month, 3.08%; 24-month,
3.40%. These swaps are for quarterly settlement versus 3-month LIBOR and use the
actual/360 day-count convention. The next discount factor,

5
LIBOR
DF
, comes from
solving this equation:

1= (2.44%*92/ 360*0.998724) + (2.44%*92/360*0.994915)
+ (2.44%*91/360*0.987925) + (2.44%*90/360*0.979152)
+ (2.44%*90/360 +1) *
5
LIBOR
DF
,
5
LIBOR
DF
= 0.969457

This treats the swap as a 15-month, 2.44% fixed-rate, non-amortizing (i.e., bullet) bond
priced at a par value of 1. [All of the reported results for this and the following equations
are calculated on a spreadsheet to preserve accuracy in the bootstrapping process, which
is sensitive to rounding. The rounded results from the calculations with full precision are
shown in the equations for consistent exposition.]

12

The discount factor for the sixth quarterly period,

6
LIBOR
DF
, uses

1
LIBOR
DF

through

5
LIBOR
DF
along with the 18-month swap fixed rate of 2.76%.

1= (2.76%*92/ 360*0.998724) + (2.76%*92/360*0.994915)
+ (2.76%*91/360*0.987925) + (2.76%*90/360*0.979152)
+ (2.76%*92/360*0.969457) + (2.76%*92/360 +1) *
6
LIBOR
DF
,

6
LIBOR
DF
= 0.958690

Repeating the bootstrapping process for the seventh and eighth periods, which have 91
and 90 days in the quarter, obtains

7
LIBOR
DF
= 0.946531 and

8
LIBOR
DF
= 0.933045. The
general formula for bootstrapping LIBOR discount factors from at-market swap fixed
rates (SFR
n
) is:


n
LIBOR
DF
=
1
n
SFR
*
j *
j
LIBOR
DF
A
j = 1
n 1

1+
n
SFR
*
n
A ( )
, n > 4 (2)
The implied forward rate, sometimes called the projected rate, for 3-month
LIBOR between period n 1 and period n based on the LIBOR discount factors is
designated

n 1, n
LIBOR
IFR
. The sequence of implied forwards is bootstrapped with this
formula:


n 1, n
LIBOR
IFR
=
n 1
LIBOR
DF
n
LIBOR
DF
1
|
\


|
.
|
|
*
1
n
A
(3)
For example, the 7 x 8 implied rate between months 21 and 24 is 5.7815%.


7, 8
LIBOR
IFR
=
0.946531
0.933045
1
|
\

|
.
| *
1
90/ 360
= 0.057815
The implied, or projected, LIBOR forward curve is particularly useful in pricing options
on swaps (i.e., swaptions) and non-standard interest rate swaps that have, for instance,
a deferred start date or a notional principal that varies over the lifetime of the contract.

13

The bootstrapped LIBOR discount factors and implied forward rates are summarized in
Exhibit C.
The 5.26%, 2-year, USD 100 million, off-market swap can be valued by
comparison to the at-market swap having a fixed rate of 3.40%. Its market value using
the LIBOR discount factors, denoted MV
LIBOR
, is USD 3,662,844.


LIBOR
MV
= 0.0526 0.0340 ( )*100,000,000*
j
A
j = 1
8
*
j
LIBOR
DJ
= 3,662,844
The swap is an asset to the fixed-rate receiver, and an equivalent liability to the payer.
This amount is higher than the cursory value calculated at the beginning of the section
because the actual/360 day-count is used, and the discount factors reflect lower rates due
to the upward slope to the swap curve.
The combination-of-bonds approach and LIBOR discounting produce the same
value for the swap. The implicit FRN has a market value of USD 100 million. Often par
value on a rate reset date is simply assumed for a floating-rate note, but it is useful in
understanding the implications of OIS discounting to calculate its price by applying the
LIBOR discount factors to the sequence of implied, or projected, LIBOR forward rates.

FRN
MV
=100,000,000*
j
j 1, j
LIBOR
IFR
* A
j = 1
8
*
j
LIBOR
DF
+100,000,000*
8
LIBOR
DF
=100,000,000

The 5.26% fixed-rate note is priced at a premium above par value, USD 103,662,844,
because current swap market rates are lower than the contractual ratein terms of bond
valuation, its coupon rate exceeds the yield to maturity.

FIXED
MV
=100,000,000*0.0526*
j
A
j = 1
8
*
j
LIBOR
DF
+100,000,000*
8
LIBOR
DF
=103,662,844


14

When the implicit bonds are priced using LIBOR discount factors, the difference in the
bond prices determines the market value of the swap.
844 , 662 , 3 000 , 000 , 100 844 , 662 , 103 = = =
MV MV MV
FRN FIXED LIBOR

The key assumption behind this valuation using LIBOR discounting is either: (1)
the swap is uncollateralized and the fixed-rate payer, for which the swap is a liability, is a
LIBOR flat credit risk, or (2) the swap is collateralized (or centrally cleared) and LIBOR
discount rates are a reasonable proxy for the risk-free yield curve. Nowadays,
collateralization is the norm and the LIBOR-OIS spread is not insignificant. Therefore,
LIBOR discounting is no longer appropriate for collateralized or centrally cleared
transactions. That explains why OIS discounting is becoming the new standard for
interest rate swap valuation.
Suppose the 3-month fixed rate is 0.10% on an overnight indexed swap for a
notional principal of USD 100 million. At settlement, the settlement payoff will be based
on the difference between the fixed and floating legs on the swap. Assuming 92 days for
the quarter and an actual/360 day-count, the fixed leg is USD 25,556.

100,000,000*
92
360
*0.0010 = 25,556
The floating leg depends on the sequence of realized daily reference rates.

100,000,000* 1+
1 EFF
360
|
\

|
.
|
* 1+
2 EFF
360
|
\

|
.
|
*...* 1+
92 EFF
360
|
\

|
.
|
1



(

(
EFF
1
, EFF
2
,, EFF
92
are the reported daily observations for the effective fed funds
rate.
4
Net settlement on the OIS is the difference between the two legs.

15

OIS fixed rates out to 12 months use simple interest, following market practice for
LIBOR in the money market. In the same manner as equation (1), OIS discount factors
for the first four quarters are calculated as:

( ) +
=
=
n
j n j
OIS
n
A OIS
DF
1
* 1
1
, n = 1 to 4 (4)
Suppose that the OIS rates are: 3-month, 0.10%; 6-month, 0.60%; 9-month, 1.20%; 12-
month, 1.70%. These time periods translate to 92, 184, 275, and 365 days. Using
equation (4), the first two OIS discount factors are:


1
OIS
DF
=
1
1+ 0.0010*92/ 360 ( )
= 0.999745,


2
OIS
DF
=
1
1+ 0.0060*184 / 360 ( )
= 0.996943
In the same manner,

3
OIS
DF
= 0.990917 and

4
OIS
DF
= 0.983056.
Consistent with LIBOR swaps, OIS contracts for tenors longer than 12 months
entail periodic settlement payments. Assume that these are quarterly settlements for an
actual/360 day-count. The OIS fixed rates are: 15-month, 2.00%; 18-month, 2.30%, 21-
month, 2.60%; 24-month, 2.90%. These assumed swap rates track a LIBOR-OIS spread
in the 40-50 basis point range. The general formula for bootstrapping the OIS discount
factors beyond 12 months has the same structure as equation (2):


n
OIS
DF
=
1
n
OIS
*
j *
j
OIS
DF
A
j = 1
n 1

1+
n
OIS
*
n
A ( )
, n > 4 (5)
The OIS discount factor for the fifth quarter (n = 5) is 0.974724.

( )
974724 . 0
360 / 92 * 0200 . 0 1
* 0200 . 0 1
4
* 1
5
=
+

=
= j
OIS
OIS
A
DF
DF
j
j


16

The remaining OIS discount factors are:

6
OIS
DF
= 0.965259 ,

7
OIS
DF
= 0.954878, and

8
OIS
DF
= 0.9433. The assumed OIS fixed rates and the corresponding discount factors are
tabulated in Exhibit 4.
Now suppose that both the 5.26% off-market and the 3.40% at-market interest
rate swaps are collateralized (or centrally cleared) so that OIS discounting is appropriate.
The market value is USD 3,681,873.

OIS
MV
= 0.0525 0.0340 ( )*100,000,000*
j
A
j = 1
8
*
j
OIS
DJ
= 3,681,873
This is higher than the market value using LIBOR discount factors, USD 3,662,844. The
size of the difference is a function of the gap between the contractual and mark-to-market
fixed rates, the tenor, the LIBOR-OIS spread, and the shape of the underlying yield curve.
What matters is that this market value better captures the minimal credit risk on a
collateralized (or centrally cleared) interest rate swap.
An important point is that care needs to be taken in valuing the swap using the
combination-of-bonds approach, which is common in academic textbooks, because both
implicit bonds need to be priced as risk-free securities. The market value for the implicit
2-year, 5.26% fixed-rate bond using the OIS discount factors is USD 104,750,723.

FIXED
MV
=100,000,000*0.0526*
j
A
j = 1
8
*
j
OIS
DF
+100,000,000*
8
OIS
DF
=104, 750, 723

It is tempting to get the value of the implicit FRN by using the OIS discount factors on
the implied LIBOR forward curve, as reported in Exhibit C. The market value for the
FRN would be USD 101,078,899, as expected above par value because of its risk-free
status.

17


FRN
MV
=100,000,000 *
j
j 1, j
LIBOR
IFR
* A
j = 1
8
*
j
OIS
DF
+100,000,000 *
8
OIS
DF
=101,078,899

The value for the swap using OIS discounting and the combination-of-bonds approach
then is calculated to be USD 3,671,824.

OIS
MV
=104, 750, 723101,078,899 = 3,671,824
The problem is that this does not match the value using OIS discounting and the market-
to-market approach, for which the result is USD 3,681,873.
The resolution of the discrepancy is that a new implied, or projected, LIBOR
forward curve is neededone that is consistent with pricing LIBOR deposits and at-
market LIBOR swaps with OIS discount factors. For the money market segment of the
swap curve, for which observations on LIBOR deposits are used to get the discount
factors, this is the formula for n = 1 to 4:
DF
A
DF
A
IFR A
DF
LIBOR
IFR
n
OIS
n
j
j j
j n
n
j
OIS OIS
j j
n
j
OIS
OIS
n n
*
* *
1
1 , 1 1
, 1
*
*

=

= =

(6)
For n > 4, the at-market LIBOR swap fixed rates are used:

n 1, n
OIS
IFR
=
n
SFR
*
j *
j
OIS
DF
A
j = 1
n

j
j 1, j
OIS
IFR
* A *
j
OIS
DF
j = 1
n 1

n
OIS
n
A
* DF
(7)
The new sequence of implied LIBOR forwards is included in Exhibit D. The
important result is that the market value of the implicit FRN for OIS discounting is USD
101,068,849.

FRN
MV
=100,000,000 *
j
j 1, j
OIS
IFR
* A
j = 1
8
*
j
OIS
DF
+100,000,000 *
8
OIS
DF
=101,068,849


18

The value of the 5.26%, 2-year collateralized swap using the combination-of-bonds
approach is USD 3,681,873, now matching the result for the mark-to-market method.

OIS
MV
=104, 750, 723101,068,849 = 3,681,873
Pricing and valuing LIBOR swaptions and non-standard swaps are other applications for
equations (6) and (7). These procedures require a LIBOR forward curveand it is the
implied LIBOR forward curve consistent with OIS discounting that is relevant.

Conclusion
The switch from LIBOR to OIS discounting in the valuation of collateralized (or
centrally cleared) interest rate swaps is not a technical advance coming out of financial
engineering or math finance research projects. In fact, the same bootstrapping procedures
are used, albeit with some adjustments to address the differences in the factors driving the
volatility in LIBOR and OIS rates and data availability. The switch is more conceptual in
that it establishes that counterparty credit risk and collateralization are significant
elements in valuation and that LIBOR swap discount factors no longer are a reasonable
proxy for the risk-free yield curve. Risk managers need to be aware of this switch even if
their swaps are not collateralized or centrally cleared; financial educators need to
introduce OIS discounting into their swap training materials and textbooks.

19

Notes

1. For an illustration of these technicalities, see the articles by Justin Clarke of Edu-Risk
International, which are available at www.edurisk.ie.

2. A third interpretation, which is not typically used in practice, is that an interest rate
swap is a long/short combination of an interest rate cap and floor that have strike rates
equal to the fixed rate on the swap; see Brown and Smith (1995).

3. This example of swap valuation using LIBOR discounting is based on Smith (2011).

4. This description of the calculation of the floating leg on an OIS contract is an
abstraction. In practice, weekends and holidays are handled with an odd mix of simple
and compound interest. Suppose that for a 5-day OIS, the effective fed funds rate is
0.09% on Thursday, 0.10% on Friday, and 0.11% on Monday. The Friday rate is used for
Saturday and Sunday, however, on a simple interest basis. The floating leg would be
calculated as:


100,000,000* 1+
0.0009
360
|
\

|
.
| * 1+
3*0.0010
360
|
\

|
.
| * 1+
0.0011
360
|
\

|
.
| 1



(

(
As formulated in the text, the Friday rate would be compounded for the three days:


100,000,000* 1+
0.0009
360
|
\

|
.
| *
3
1+
0.0010
360
|
\

|
.
|
* 1+
0.0011
360
|
\

|
.
| 1





(

(
(
(

20

Exhibit A: 2-year, 5.26% Interest Rate Swap





Fixed-Rate Payer

The Payer
Fixed-Rate
Receiver

The Receiver
5.26%
Fixed Rate
3-Month
LIBOR

21

Exhibit B: Counterparty Balance Sheets
Upper Panel: At-market Interest Rate Swap





Middle Panel: Off-market Interest Rate Swap, Swap Rates Fall





Lower Panel: Off-market Interest Rate Swap, Swap Rates Rise






Fixed-Rate Receiver Fixed-Rate Payer

OCI

OCI


OCI
OCI
Fixed-Rate Receiver Fixed-Rate Payer
Swap Swap


OCI
OCI
Fixed-Rate Receiver Fixed-Rate Payer
Swap Swap

22

Exhibit C: LIBOR Discounting








Period
Number of
Days
LIBOR
Deposits and
Swap Fixed
Rates
LIBOR
Discount
Factors
Implied LIBOR
Forward Rates
1 92 0.50% 0.998724 0.5000%
2 92 1.00% 0.994915 1.4981%
3 91 1.60% 0.987925 2.7989%
4 90 2.10% 0.979152 3.5840%
5 92 2.44% 0.969457 3.9132%
6 92 2.76% 0.958690 4.3949%
7 91 3.08% 0.946531 5.0818%
8 90 3.40% 0.933045 5.7815%

23

Exhibit D: OIS Discounting

Period
Number of
Days
OIS
Fixed Rates
OIS
Discount Factors
Implied LIBOR
Forward
1 92 0.10% 0.999745 0.5000%
2 92 0.60% 0.996943 1.5014%
3 91 1.20% 0.990917 2.8223%
4 90 1.70% 0.983056 3.6477%
5 92 2.00% 0.974724 3.8138%
6 92 2.30% 0.965259 4.3888%
7 91 2.60% 0.954878 5.0717%
8 90 2.90% 0.943385 5.7658%


24


References

Brown, Keith C. and Donald J. Smith, Interest Rate and Currency Swaps: A Tutorial,
Research Foundation of the Institute for Chartered Financial Analysts, 1995, available at
the CFA Institute website.


Clarke, Justin, Swap Discounting & Pricing Using the OIS Curve, Edu-Risk
International, available at www.edurisk.ie.

Clarke, Justin, Constructing the OIS Curve, Edu-Risk International, available at
www.edurisk.ie.

Johannes, Michael and Suresh Sundaresan, The Impact of Collateralization on Swap
Rates, Journal of Finance, Vol. LXII, No. 1, February 2007.

Nashikkar, Amrut, Understanding OIS Discounting, Barclays Capital Interest Rate
Strategy, February 24, 2011.

Smith, Donald J., Bond Math: The Theory Behind the Formulas, Wiley Finance, 2011.