The global financial crisis caused a paradigm shift in the market as participants began to recognize the credit risk inherent even in short-term transaction rates used as the basis for calculating LIBOR. Credit spreads ballooned during the crisis, and while they have declined since then, they haven’t returned to pre-crisis levels due to this paradigm shift. Derivatives dealers have increasingly moved to using the Overnight Index Swap (OIS) rate for discounting cash flows and valuing interest rate swaps. Many market participants have come to consider OIS a better measure of a ‘risk-free’ rate. The OIS rate corresponds to the effective Fed funds rate for USD, EONIA for EUR, SONIA for GBP, and TONAR for JPY.
In spite of the move to OIS for discounting cash flows and valuing interest rate swaps, the market continues to specify floating rate coupons by indexing them to LIBOR. Therefore, when valuing an interest rate swap on a market-consistent basis, a dual-curve framework is required instead of a traditional single-curve framework. The transition from a single-curve to dual-curve valuation framework changes the calculation method used to construct the LIBOR curve from market data. In particular, an OIS discount curve must be used as a basis for constructing a LIBOR curve from market swap, Eurodollar futures, and FRA quotes.
The 2013 Milliman Derivatives Survey showed that only one-third of insurers were using or planning to use OIS discounting for their asset valuations for risk management. For liabilities, only 7% of respondents plan to switch to OIS discounting, and it appears likely that life insurers’ liabilities will continue to be valued using LIBOR-based discounting.
Given the marketplace move towards using OIS discounting for interest rate swaps, financial institutions that continue to price and risk-manage interest rate swaps under the traditional single-curve framework using LIBOR face a number of key consequences:
- Swap values will be different under the dual-curve OIS valuation framework
- Interest rate DV01 of swaps calculated with LIBOR discounting will underestimate the DV01s of the same swaps discounted with OIS
- Interest rate swaps will be exposed to LIBOR-OIS spread movements
The Financial Stability Board (FSB) issued a report titled ‘Reforming Major Interest Rate Benchmarks’ in July 2014, proposing multiple possible ‘risk-free’ rates for various markets and currencies. Regardless of which curve is ultimately chosen by the regulators, the traditional single-curve LIBOR-discounting framework may no longer be appropriate to use, especially for interest rate swaps used to hedge VA liabilities for reasons noted above.