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John Hull and Alan White

March, 2012

ABSTRACT

Traditionally practitioners have used LIBOR and LIBOR swap rates as proxies for risk-free rates

when valuing derivatives. This practice has been called into question by the credit crisis that

started in 2007. Many banks consider that overnight indexed swap (OIS) rates should be used for

discounting when collateralized portfolios are valued and that LIBOR should be used for

discounting when portfolios are not collateralized. This paper critically examines this practice. It

agrees that the OIS rate is a better proxy for the risk-free rate than LIBOR and argues that it

should be used for discounting when both collateralized and non-collateralized portfolios are

valued. LIBOR discounting can be made to work for non-collateralized portfolios, but is not the

best approach.

2

LIBOR vs. OIS: The Derivatives Discounting Dilemma

1. Introduction

The risk-free term structure of interest rates is a key input to the pricing of derivatives.

Academic research usually assumes that the government borrowing rate is the risk-free rate.

However, in the United States, Treasury rates tend to be low compared with the rates offered on

other very-low-credit-risk instruments. One reason for this is the tax treatment of Treasury

instruments. (Income from Treasury instruments is exempt from tax at the state level.) This has

led researchers such as Elton et al (2001) to calculate credit spreads relative to the Treasury rate

and attempt to identify a number of components, one of which is tax component.

Derivatives dealers have traditionally used LIBOR and LIBOR swap rates as proxies for the risk-

free rate.

1

They calculate a risk-free zero curve using LIBOR rates, Eurodollar futures rates, and

swap rates. LIBOR rates can be regarded as the short-term borrowing rates of AA-rated financial

institutions. Collin-Dufresne and Solnik (2001) show that swap rates are continually refreshed

LIBOR rates and carry the same risk as a series of short-term loans to AA-rated financial

institutions. When swap rates are used to bootstrap the LIBOR curve the resultant rates, in

normal circumstances, are those that would apply to relatively low-risk (but not zero-risk)

lending. For example, the credit risk inherent in a 5-year swap rate is the credit risk in 20

successive three-month loans to AA-rated financial institutions.

The use of LIBOR as a proxy for the risk-free rate was called into question by the credit crisis

that started in mid-2007. Banks became increasingly reluctant to lend to each other because of

concerns about the possibility of default. As a result LIBOR quotes started to rise. The TED

spread, which is the spread between three-month U.S. dollar LIBOR and the three-month U.S.

Treasury rate, is less than 50 basis points in normal market conditions. Between October 2007

1

LIBOR is the London Interbank Offer Rate. It is calculated by the British Bankers Association each day at

11:00am. The rate is determined by asking a panel of large banks to estimate at what rate they could borrow money

in a particular currency on an unsecured basis for periods from one-day to one year. For each maturity the highest

25% and lowest 25% of estimated rates are discarded and the remaining rates are averaged and published as LIBOR.

LIBOR rates are published for many currencies.

3

and May 2009, it was rarely lower than 100 basis points and peaked at over 450 basis points in

October 2008.

The realization that LIBOR could no longer be used as a proxy for the risk-free rate and the

increasing use of collateral to reduce credit risk in derivatives portfolios has led banks to use

more than one discount rate when valuing derivatives. It is becoming normal practice for banks

to use zero-coupon interest rates calculated from overnight indexed swap (OIS) rates for

discounting when collateralized portfolios are considered, while those calculated from LIBOR

and LIBOR swap rates are used for discounting when non-collateralized portfolios are

considered.

2

In this paper we make the argument that this approach can give correct answers if the impact of

the dealers and the counterpartys credit risk is calculated in a particular way. But it is not the

best way of proceeding. The valuation of a derivative should be separated from credit risk

adjustments and other adjustments for the interest paid on collateral. One thing is clear from the

crisis: OIS rates do provide a better proxy for the risk-free rate than LIBOR and LIBOR swap

rates. However, the correct approach to valuing derivatives is unchanged. Derivatives should

first be valued assuming neither side will default and that no collateral is posted. The adjustments

to reflect counterparty credit risk, dealer credit risk, and interest paid on collateral should be

made elsewhere.

The credit risks of dealers and their counterparties in derivatives trading are reflected in credit

value adjustment (CVA) and debit value adjustment (DVA) calculations.

3

The CVA calculated

by a dealer for a counterparty is an estimate of the amount by which the value of its derivatives

portfolio with the counterparty should be reduced to reflect the possibility of the counterparty

defaulting during the life of the derivatives portfolio. The DVA is an estimate of the amount by

which the value of the derivatives portfolio should be increased to reflect the possibility of the

dealer defaulting during the life of the portfolio. Derivatives should first be valued assuming no

chance of default by the dealer or the counterparty. The value reported in the accounts should

2

See for example Cameron (2011). A discussion of this issue involving representatives from Barclays Bank and

Royal Bank of Scotland is at www.rbsm.com/rbsmassets/PDFs/RBS_Risk_0610.pdf and was published in the June

2010 issue of Risk.

3

For a discussion of CVA and DVA, see Gregory (2009 ) or Hull and White (2012).

4

then be the no-default value less the CVA plus the DVA. CVA and DVA calculations are also a

convenient place to take account of situations where the interest rate paid on collateral is

different from the risk-free rate.

In this paper, we start with a discussion to clarify the apparent differences between the

Eurodollar, federal funds, and repo overnight rates. We explain how the OIS rate is calculated,

why the OIS rate is a good proxy for the risk-free rate, and how a zero curve is constructed from

OIS swap rates. We then move on to consider how discount rates should be chosen when

derivatives are valued and consider potential pitfalls. Results are illustrated with a numerical

example.

2. Overnight Rates

Banks have many ways of financing their activities. In this section we will discuss the overnight

financing possibilities that are available to banks. One reason for focusing on overnight funding

is that this is usually the marginal source of bank funding and so its cost is critical in assessing

the value of all derivative transactions that the bank undertakes. A second reason is that the cost

of overnight funds acts as the anchor in the construction of the term structure. Finally, the

overnight funding rate is the best proxy for the instantaneous short rate that is used in many of

the theoretical models for the valuation of derivative securities.

Banks can borrow money in the overnight market on a secured or unsecured basis. Overnight

U.S. dollar secured debt can be raised in the form of an overnight repurchase agreement (a repo)

or at the Federal Reserves Discount Window.

4

Unsecured U.S. dollar overnight financing comes

in the form of Federal Funds and Eurodollars. In the rest of this section we will argue that there

is little difference in the costs of these different forms of borrowing and that the effective federal

funds rate is the best proxy for a risk-free rate of interest.

4

For a discussion of the repo market see Stigum (1990) or Demiralp et al (2004). For a discussion of the Discount

Window see Furfine (2004).

5

Federal funds are balances held at Federal Reserve Banks. Most large North American

depository institutions and many large European and Asian financial institutions maintain

accounts at the Reserve banks. Fedwire is the name given to the real time wire transfer system

run by the Federal Reserve. Institutions that maintain accounts at the Reserve banks have access

to Fedwire and use it to make payments by transferring deposits from their account to the

accounts of other institutions at the Reserve Banks. Every transaction over Fedwire is

immediately debited to the paying banks account and credited to the receiving banks account.

The payments may be related to the purchase and sale of securities, bank loans, other

commercial transactions, and federal funds loans. Approximately 500,000 transactions per day

with a total value of $2.7 trillion per day were processed in the second quarter of 2011.

Federal funds loans are unsecured overnight loans between financial institutions carried out

using the Fedwire system. These loans represent about 5% of the Fedwire transactions and about

15% of the dollar volume.

5

A large fraction of the federal funds loans are brokered. The

brokerage fee is roughly equivalent to an increase of about 2 basis points in the interest rate on

the loan. Trades are initiated anonymously and the borrowers identity is revealed to the lender

when the amount of the loan and the interest rate are agreed. The transaction proceeds only if

there is an existing credit line between the parties.

6

Major brokers report the dollar amount

loaned at each interest rate to the New York Federal Reserve Bank of New York (FRBNY)

daily.

7

The statistics reported by the brokers are used by FRBNY to calculate the average interest rate

paid on federal funds loans. This average is called the effective federal funds rate. The

effective federal funds rate is monitored by the FRBNY. If it is too high relative to the target rate

set by the Federal Open Market Committee, the FRBNY purchases assets in the open market

from banks. The assets are paid for by a transfer from the FRBNY reserve accounts to the banks

reserve account, increasing the total federal funds balances held by banks. This increase in the

supply of loanable balances results in lower interest rates for federal funds loans. If the effective

5

See Bech and Atalay (2008).

6

See Bartolini et al (2008a).

7

See Demiralp et al (2004). Most federal funds transactions take place at interest rates that are an integral multiple

of either one basis point or one-thirty-second of one per cent.

6

rate is too low the FRBNY acts to reduce the total federal funds balances held by banks. Through

this mechanism the FRBNY is able to keep the effective federal funds rate close to the target

rate.

While the FRBNY controls the average interest rate, on each day there is cross-sectional

variation in the rates charged on individual loans.

8

Between January 2001 and July 2011 the

standard deviation of the distribution of rates charged has varied from a low of one basis point

(almost all loans made at the same rate that day) to a high of 1.95% (September 30, 2008). The

dispersion of rates charged depends on the level of uncertainty in the market. The average daily

standard deviation between January 2001 and September 12, 2008 was 9.5 basis points, between

September 15, 2008 and December 31, 2008 it was 42.2 basis points, and from January 2, 2009

to July 2011 it was 4.1 basis points.

Overnight Eurodollar loans are the transfer of off-shore U.S. dollar balances from one bank to

another. U.S. based banks do not borrow Eurodollars directly but do so indirectly through their

non-U.S. offices or International Banking Facilities. This transfer is carried out by payment

through Fedwire or the Clearing House Inter-Bank Payment System (CHIPS), a wire transfer

system operated by private institutions. Until the end of 1990, the federal funds market was the

primary source of overnight borrowing by banks. However, the elimination of reserve

requirements on Eurodollar liabilities in 1990 led to a sharp growth in Eurodollar financing.

Since 1990 more U.S. bank financing has been done through the Eurodollar channel than with

federal funds.

9

There is little difference between overnight borrowing of federal funds or Eurodollars. The

primary distinction between the two forms of overnight financing is that money market brokers

do not report the statistics for Eurodollar financing as they do for federal funds. As a result, the

only easily available measure of the cost of overnight borrowing in the Eurodollar market is the

level of overnight LIBOR reported by the British Bankers Association. On average, overnight

LIBOR was 6.6 basis points higher than the effective funds rate between January 2001 and April

8

Furfine (2001) shows that banks with better credit characteristics pay lower interest rates. Also large banks pay

lower interest relative to smaller banks, and the interest rate on large loans is about 5 basis points lower than the rate

on small loans.

9

See Bartolini et al (2008b).

7

2011 (omitting the tumultuous period from August 2007 to December 2008). The average

difference in the period August 2007 to December 2008 was 33.9 basis points.

Given the substitutability of Eurodollar and federal funds financing the apparent difference

between the rates seems difficult to explain. This issue is addressed by Bartolini et al (2008b)

who use a proprietary data base of brokered Eurodollar and federal funds transactions in New

York. They find that for this homogeneous set of transactions there is no material difference

between the rates charged on the two types of financing. They attribute the observed differences

to timing effects, the composition of the pool of borrowers in London as compared to New York,

market microstructure differences between the dominant settlement mechanisms in London

(CHIPS) and New York (Fedwire), and the difference between transaction prices (the brokered

trades) and quotes which just provide the starting point for a negotiation.

The overnight rate, whether federal funds or overnight LIBOR, is a rate on unsecured borrowing

and as such is not a risk-free rate. However, we believe that the effective federal funds rate is a

good proxy for a risk-free rate for two reasons. First, the effective federal funds rate is the

average overnight borrowing rate for banks. As such it reflects the average overnight risk of

default in the banking sector. Presumably the probability that an average bank will default in the

next 24 hours is extremely small.

What about the possibility that the average overnight rate is raised by the rates charged to more

risky institutions? We believe that more risky institutions cannot fund in the federal funds

market. It is well known that this form of lending is unsecured.

10

As a result banks monitor each

other closely when lending in this market. No bank would make an unsecured overnight loan to

another bank if it thought there was a perceptible chance that the borrower might default in the

next 24 hours. The upside associated with the loan is small and, if a default occurs, the downside

is large. This ensures that the effective federal funds rate reflects the credit quality of very good

10

The collapse of Franklin National Bank on October 8, 1974 brought to bankers attention that the loans were

unsecured and led to closer monitoring of counterparty credit risk in the federal funds market.

8

quality banks.

11

Because of this we believe that the credit component of the effective federal

funds rate is very small.

Longstaff (2000) and other authors argue that the overnight repo rate is a better indicator of the

risk-free rate since the borrowing is collateralized. Certainly a secured loan is subject to less

credit risk than an unsecured loan. However there is substantial cross-sectional variation in repo

rates related to the type of collateral posted. Up to mid-2007, rates for U.S. repos secured by

federal government securities were 5 to 10 basis points below the federal funds rate while for

repos secured by U.S. agencies the rates were about one basis point below the federal funds rate.

During the crisis, the rate for repos secured by federal government securities fell relative to the

federal funds rate, but for other repos the rate rose relative to this rate. These cross-sectional

variations suggest that market microstructure issues may play a larger role in explaining the

difference between repo and federal funds rates than credit risk does.

12

As a result we believe

that the repo rate is not a better measure of the risk-free overnight rate than the effective federal

funds rate.

Our discussion of overnight rates has been couched in terms of U.S. dollar interest rates but it is

not unique to this currency. Similar overnight markets with similar characteristics exist in Euro,

Sterling and other major currencies.

3. Overnight Index Swaps

The credit crisis showed that LIBOR and LIBOR swap rates can incorporate significant risk

premia when markets are stressed. This has led practitioners to search for an alternative proxy for

the risk-free rate. The market has concluded that the overnight indexed swap (OIS) rates, which

are derived from effective federal funds rates, are the best proxy available. As indicated in the

11

While it is possible that the cross-sectional variation in lending rates observed in the fed funds market on any day

reflects credit risk differences, the differences may also reflect the relative bargaining power of each party to the

loan. See Bech and Atalay (2008). Since overnight loans may be negotiated any time during the day there may also

be differences arising from changing rates during the day.

12

For example, it is possible that lenders in the repo market rather than making secured loans are using the market to

acquire ownership of securities that are otherwise difficult to acquire. See BIS Quarterly Review (December 2008).

9

previous section, we believe that this conclusion is supported by the available empirical

evidence.

Overnight index swaps are interest rate swaps in which a fixed rate of interest is exchanged for a

floating rate that is the geometric mean of a daily overnight index rate. The calculation of the

payment on the floating side is designed to replicate the aggregate interest that would be earned

from rolling over a sequence daily loans at the overnight rate. In U.S. dollars, the index rate is

the effective federal funds rate. In Euros, it is the Euro Overnight Index Average (EONIA) and,

in sterling, it is the Sterling Overnight Index Average (SONIA).

OIS swaps tend to have relatively short lives (often three months or less). However, transactions

that last as long as five to ten years are becoming more common. For swaps of one-year or less

there is only a single payment at the maturity of the swap equal to the difference between the

fixed swap rate and the compounded floating rate multiplied by the notional and the accrual

fraction. If the fixed rate is greater than the compounded floating rate, it is a payment from the

fixed rate payer to the floating rate payer; otherwise it is a payment from the floating rate payer

to the fixed rate payer. Similar to LIBOR swaps, longer term OIS swaps are divided into 3-

month sub-periods and a payment is made at the end of each sub-period.

In Section 1 we mentioned the continually-refreshed argument of Collin-Dufresne and Solnik

(2001). This shows that the 5-year swap rate for a transaction where payments are exchanged

quarterly is equivalent to the rate on 20 consecutive 3-month loans where the counterpartys

credit rating is AA at the beginning of each loan. A similar argument applies to an OIS swap

rate. This rate is the interest that would be paid on continually refreshed overnight loans to

borrowers in the overnight market.

There are two sources of credit risk in an OIS. The first is the credit risk in fed funds borrowing

which we argue is very small. The second is the credit risk arising from a possible default by one

of the swap counterparties. This possibility of counterparty default is liable to lead to an

adjustment to the fixed rate. The size of the adjustment depends on the slope of the term

structure, the probability of default by a counterparty, the volatility of interest rates, the life of

the swap, and whether the transaction is collateralized. The size of the adjustment is generally

10

very small. In the case where the two sides are equally creditworthy and the term structure is flat

it is zero. It can also reasonably be assumed to be zero in collateralized transactions.

13

Based on

these arguments we conclude that the OIS swap rate is a good proxy for a longer term risk-free

rate.

The three-month LIBOR-OIS spread is the spread between three-month LIBOR and the three-

month OIS swap rate. This spread reflects the difference between the credit risk in a three-month

loan to a bank that is considered to be of acceptable credit quality and the credit risk in

continually refreshed one-day loans to banks that are considered to be of acceptable credit

quality. In normal market conditions it is about 10 basis points. However, it rose to a record 364

basis points in October 2008. By a year later, it had returned to more normal levels, but it rose to

about 30 basis points in June 2010 and to 50 basis points at the end of 2011 as a result of

European sovereign debt concerns.

The OIS zero curve can be bootstrapped similarly to the LIBOR/swap zero curve. If the zero

curve is required for maturities longer than the maturity of the longest OIS a natural approach is

to assume that the spread between the OIS zero curve and the LIBOR/swap zero curve is the

same at the long end as it is at the longest OIS maturity for which there is reliable data.

Subtracting this spread from the LIBOR zero curve allows it to be spliced seamlessly onto the

end of the OIS zero curve. In this fashion a risk-free term structure of interest rates can be

created.

4. Collateralized vs. Non-Collateralized Portfolios

It is becoming standard market practice to use the OIS curve for discounting when collateralized

portfolios are valued and the LIBOR/swap curve for discounting when non-collateralized

portfolios are valued. In this section we examine whether this practice has a sound theoretical

basis.

An important point to bear in mind is that interest rates play two roles in the valuation of most

derivatives. Interest rates define the expected return from stocks, bonds, and other underlying

13

Legislation requiring standard swaps to be cleared centrally means that swap quotes are likely to reflect

collateralized transactions in the future.

11

assets in a risk-neutral world so that the expected payoff on the derivative can be calculated.

They also define the rate used for discounting the expected payoff. In the rest of this section we

are concerned only with the second role of interest rates; that is, we are concerned exclusively

with the discount rate. The interest rate used to determine the return on the underlying asset

price in a risk-neutral world should always be chosen as the risk-free rate and we have already

argued that the OIS rate is the best proxy for the risk-free rate.

Collateralized Portfolios

In order to develop our ideas it is convenient to start by making the idealized assumption that a

collateral is posted continuously by both sides with zero threshold and that no time elapses

between a failure to post collateral and the close-out of the underlying derivatives portfolio at its

no-default value. (We will relax this assumption later.) In this case, the derivatives portfolio is

riskless for both parties. The collateral posted by one side at any given time is exactly equal to

max(V, 0) where V is the value to the other side.

Traditional finance theory shows that, in the absence of credit risk, expected cash flows should

be estimated in a risk-neutral world and discounted at the risk-free rate. The OIS rate is, as

explained in Sections 2 and 3, the best proxy for the risk-free rate and so this is the rate that

should be used for discounting. If the rate paid on cash collateral is the effective fed funds rate,

no further adjustments are necessary because as explained earlier the effective fed funds rate can

be regarded as the one-day OIS rate. Earning or paying interest at the discount rate does not

affect the valuation.

If the rate paid on cash collateral is significantly less than the effective fed funds rate, derivatives

traders are likely to prefer to post securities rather than cash, even though these are subject to a

haircut. If the rate paid is significantly more than the effective fed funds rate, they are likely to

prefer to post cash. Suppose for a moment that only cash collateral is permitted. If the daily fed

funds rate is

f

r and the daily rate paid on the collateral is .

c

r With the idealized collateral

arrangements we are considering, the situation is equivalent to one where a) the rate paid on the

collateral is

f

r and b) the derivatives portfolio provides a daily yield equal to

f c

r r . The impact

12

of the yield is to reduce the return provided by the derivative by

f c

r r . This can be taken into

account by changing the discount curve from the OIS curve to one corresponding to .

c

r For

example, if the rate paid on collateral is x basis points below the fed funds rate, the discount

curve should be x basis points below the OIS curve. If a constant interest rate, y, is paid on

collateral the discount curve should be flat and equal to y.

We now consider the more general situation where collateral is posted but not in the idealized

way described above. Many different collateral arrangements are observed in practice. If the two

parties are not equally creditworthy, collateral arrangements are likely to favor the stronger

party. Typically, the collateralized portfolio is not totally free of credit risk for either side. This is

because some time always elapses between a failure to post collateral by one side and an unwind

of the portfolio by the other side. (This is referred to as the cure period or the margin period at

risk.)

CVA and DVA calculations take account of both the rules for determining collateral

requirements and the cure period. The life of the derivatives portfolio between the dealer and its

counterparty is divided into a number of time steps and the value of the derivatives portfolio is

simulated in a risk neutral world. On each simulation trial the value of the portfolio to the dealer

and the collateral available to the dealer if there is a default are calculated at the midpoint of each

time step.

14

This allows the net exposure conditional on default to be calculated. The dealers

credit cost is obtained by calculating the product of the probability of a default and the present

value of the net exposure for each interval, and then summing over all intervals. The

counterpartys credit cost is calculated similarly by considering the dealers probability of default

and the counterpartys exposure to the dealer. CVA is the average of the dealers credit cost

across all simulation trials; DVA is the average of the counterpartys credit cost across all

simulation trials. The value of the derivatives portfolio to the dealer is

f

nd

CVA+DVA (1)

where f

nd

is the no default value.

14

The collateral available typically depends on the value of the portfolio several days earlier when the counterparty

is assumed to stop paying collateral.

13

As discussed above, if the interest rate on collateral is the (fed funds) risk-free rate, the interest

paid on collateral has no effect on valuation. The impact on the value of an interest rate different

from the effective fed funds rate can most easily be calculated at the same time as CVA and

DVA. On each simulation trial the collateral level is calculated at each of the times considered

and this is used to estimate the present value difference between the actual interest paid and what

the interest would have been if the effective fed funds rate had been used.

15

Non-Collateralized Portfolios

Non-collateralized portfolios, like collateralized portfolios, can be valued using equation (1). The

no-default value, f

nd

, should be calculated using the OIS rate as the risk-free rate. The role of

CVA and DVA is to adjust the no-default value of the derivative so that the impact of potential

defaults by the counterparty and the dealer is taken into account. The discount rate used in the

calculation of CVA and DVA should also be the risk-free (OIS) rate of interest. It has been

shown that a detailed analysis of the cost of hedging the portfolio results in a valuation result

equivalent to that in equation (1). (See Burgard and Kjaer (2011) )

Why then does the market continue to use the LIBOR rate for discounting when non-

collateralized portfolios are valued? Part of the reason may be a reluctance to move away from

pre-crisis practice for these portfolios. Another reason may be that non-collateralized trading is

often funded at LIBOR.

The use of LIBOR/swap rates for discounting has the effect of incorporating an adjustment for

credit risk into the discount rate. It cannot then be correct to calculate CVA and DVA using

credit spreads for the counterparty and the dealer that reflect their total credit risk. If this were

done, there would be an element of double counting for credit risk.

The appendix shows that correct values are obtained if

a) The LIBOR/swap curve is used for discounting when the portfolio is valued;

15

An alternative approach is to use the rate paid on the collateral as the discount rate and adjust the value obtained

by an estimate the present value of the difference between the interest payments on the actual collateral

arrangements and the max(V, 0) idealized collateral arrangements.

14

b) CVA is calculated as the excess of the actual expected loss to the dealer from

counterparty defaults less the expected loss implicit in LIBOR/swap rates; and

c) DVA is calculated as the excess of the actual expected loss to the counterparty from a

default from a default by the dealer less the expected loss implicit in LIBOR/swap rates.

It is interesting to note that there is nothing special about the role of LIBOR/swap rates in this

result. Any yield curve can be used for discounting providing it is also used instead of

LIBOR/swap rates in b) and c) above. Note that the calculations in b) and c) are likely to give

approximately, but not exactly, the same result as using the LIBOR/swap curve as the risk-free

benchmark when credit spreads are calculated to the purposes of determining CVA and DVA.

A natural question is whether it is necessary to calculate CVA and DVA at all. Can we adjust for

credit risk by adjusting the discount rate? The appendix shows that this is possible in three

special cases. Specifically:

1. If portfolio will always have a positive value to the dealer, it can be correctly valued

using a discount curve determined from the counterpartys borrowing rates.

2. If the portfolio will always have a negative value to the dealer, it can be correctly valued

using a discount curve determined from the dealers borrowing rates.

3. If the counterparty and dealer are equally creditworthy, any portfolio can be correctly

valued using a discount curve determined from their common borrowing rate.

The most widely traded derivative is a plain vanilla interest rate swap where LIBOR is

exchanged for a fixed rate. LIBOR/swap rates are used to determine expected payoffs on this

instrument. No asset prices are modeled. As a result, one of the attractions of using LIBOR

discounting for non-collateralized trades may be that only one interest rate needs to be

considered when the trade is an interest rate swap. In reality however, this can only be an

attraction if a dealers portfolio with a counterparty consists only of interest rate swaps. Other

derivatives require interest rates to be used to define the risk-neutral growth rate of asset prices.

Also, risk-free (OIS) discount rates are necessary to calculate CVA and DVA correctly.

15

5. The Potential for Confusion

There are number of potential sources of confusion in the way discount rates are chosen. As

noted earlier, interest rates play two roles in derivatives valuation. They define asset returns in a

risk-neutral world and they are used for discounting expected payoffs. Traditional finance theory

argues that the risk-free rate should be used for both purposes. In the previous section we

outlined an approach where the LIBOR/swap curve is used for discounting and CVA and DVA

are calculated in a particular way. When this approach is adopted, it is tempting to also use the

LIBOR/swap curve to define the returns on assets in a risk-neutral world. This is not correct and

is likely to lead to lead to significant errors, particularly in stressed market conditions when the

LIBOR-OIS spread is large.

Setting this point aside, the use of the LIBOR/swap curve for discounting non-collateralized

portfolios can create a confusing situation for dealers when they develop systems for calculating

CVA and DVA. As explained in the previous section and the appendix, the correct calculation

methodology for CVA and DVA depends on whether OIS or LIBOR has been used as the

discount rate. When LIBOR has been used as the discount rate, the calculation of CVA and DVA

should reflect the fact that some credit risk has already been taken into account.

A further source of confusion lies in the discount rates used in CVA and DVA calculations.

These should be risk-free (OIS) rates even when the underlying portfolio is valued using the

LIBOR/swap rate as the discount rate. This means that the values that would be calculated by the

CVA/DVA system may not correspond to the no-default values given by the companys main

valuation system.

OIS rates must be used for discounting perfectly collateralized and partially collateralized

portfolios. It makes sense to use them for non-collateralized portfolios as well. The use of

LIBOR for discounting can in theory give the correct answer for non-collateralized transactions

if CVA and DVA are calculated in a particular way, but as has just been explained there are a

number of potential sources of confusion.

16

6. Numerical Results

To illustrate our results with a simple example, suppose that the dealers portfolio with the

counterparty consists of a non-collateralized forward contract to buy a non-dividend-paying

stock in one year. The stock price and delivery price are both $100, the volatility of the stock

price is 30% per annum, and the (OIS) risk-free rate is 3% for all maturities. We consider two

cases. Case 1 corresponds to what might be termed normal market conditions. LIBOR is 3.1%

for all maturities. The dealers and the counterpartys adjusted credit spreads are 0.5% and 2.0%,

respectively, for all maturities. Case 2 corresponds to stressed market conditions. LIBOR is

4.5% for all maturities. The dealers and the counterpartys adjusted credit are 2% and 3%,

respectively, for all maturities All rates are continuously compounded. As explained in the

appendix, the adjusted credit spread of a company is the credit spread it would have if its bonds

were treated in the same way as derivatives in the event of a default so that the claim equaled the

no-default value.

The integrals necessary to calculate CVA and DVA are evaluated by dividing the one year life of

the derivative into 200 equal time steps. Equations (A6), (A8) and (A10) in the appendix are

used to calculate expected losses between two times from credit spreads.

16

Tables 1 and 2 show that OIS and LIBOR discounting give exactly the same results if CVA and

DVA are calculated appropriately. Table 3 shows the errors that are obtained when LIBOR

discounting is mistakenly used to define the risk-neutral stock price return as well as the discount

rate. In Case 1, which corresponds to normal market conditions, the error is only 3.5%, but in

Case 2, which corresponds to stressed market conditions, it very high at 52.5%

16

When LIBOR loss rates are calculated it is the actual LIBOR-OIS credit spreads that should be used because it is

the actual LIBOR rates that are used for discounting. The counterparty and dealer credit spreads should be adjusted

credit spreads.

17

7. Conclusions

The way in which derivatives should be valued to reflect credit risk has received a great deal of

attention in the last few years. Dealers are becoming more sophisticated in the way they calculate

CVA and DVA. It is now recognized that the OIS rate is a better proxy for the risk free rate than

LIBOR and LIBOR swap rates. However, LIBOR/swap rates continue to be used for discounting

when non-collateralized portfolios are valued.

In this paper we have argued that the OIS rate should be used as the discount rate for all

derivatives portfolios, not just those that are part of collateralized portfolios. It is in theory

possible to make LIBOR discounting work for non-collateralized portfolios, but this means that

CVA and DVA calculations must be handled differently for these portfolios. This makes a

banks systems unnecessarily complicated.

The approach we propose is consistent with the hedging arguments of Burgard and Kjaer (2011)

and others. Its advantage is that it clearly separates three aspects of the valuation of a derivatives

book with a counterparty:

1. The calculation of the risk-free value of the book assuming no collateral;

2. The impact of the credit risk of the dealer and the counterparty; and

3. The impact of the interest paid on collateral or the actual cost of financing the hedge

portfolio being different from the risk-free rate.

18

References

International Banking and Financial Market Developments, Bank for International Settlements

Quarterly Review, December 2008.

Bartolini, Leonardo, Spence Hilton, and James McAndrews (2008a) Settlement Delays in the

Money Market, Federal Reserve Bank of New York Staff Report no. 319.

Bartolini, Leonardo, Spence Hilton, and Alessandro Prati, Money Market Integration, Journal

of Money, Credit and Banking, Vol. 40, No. 1 (February 2008b), pp. 193-213.

Bech, M. L. and E. Atalay, (2008) The Topology of the Federal Funds Market European

Central Bank working paper no. 986.

Brigo, Damiano and Massimo Morini (2011) Close Out Convention Tensions, Risk, 24, 12

(December 2011), 74-78.

Burgard, Christoph and Mats Kjaer, Partial Differential Equation Representations of

Derivatives with Bilateral Counterparty Risk and Funding Costs, The Journal of Credit Risk, 7,

3, Fall 2011.

Cameron, Matt, Behind the Curve, Risk, 24, 3 (March 2011).

Collin-Dufresne and Bruno Solnik, "On the Term Structure of Default Premia in the Swap and

Libor Market," The Journal of Finance, 56, 3, June 2001.

Demiralp, Selva, Brian Preslopsky, and William Whitesell (2004) Overnight Interbank Loan

Markets, Manuscript, Board of Governors of the Federal Reserve.

Elton, Edwin J., Martin J. Gruber, Deepak Agrawal, and Christopher Mann, Explaining the Rate

Spread on Corporate Bonds, Journal of Finance, 56, 1 (February 2001), 247-77.

Furfine, Craig H., Banks as Monitors of Other Banks: Evidence from the Overnight Federal

Funds Market, The Journal of Business, Vol. 74, No. 1 (January 2001), pp. 33-57.

19

Furfine, Craig H., Standing Facilities an Interbank Borrowing: Evidence from the Federal

Reserves New Discount Window, Federal Reserve Bank of Chicago working paper 2004-1.

Gregory, Jon, Counterparty Credit Risk: the New Challenge for Financial Markets, John Wiley

and Sons, 2009.

Hull, John and Alan White, The Impact of Default Risk on the prices of Options and Other

Derivative Securities, Journal of Banking and Finance, Vol. 19 (1995) pp. 299-322.

Hull, John, Mirela Predescu, and Alan White, The Relationship between Credit Default Swap

Spreads, Bond Yields, and Credit Rating Announcements, Journal of Banking and Finance, 28

(Nov. 2004) pp 2789-2811.

Hull, John and Alan White, Valuing Credit Default Swaps I: No Counterparty Default Risk,

Journal of Derivatives, Vol. 8, No. 1, (Fall 2000), pp. 29-40.

Hull, John and Alan White, CVA and Wrong Way Risk, Forthcoming, Financial Analysts

Journal, 2012.

=Longstaff, Francis A., The Term Structure of very Short-term Rates: New Evidence for the

Expectations Hypothesis, Journal of Financial Economics, Vol. 58 (2000), pp. 397-415.

Stigum, Marcia, The Money Market, 3rd ed., Homewood, Illinois, Dow Jones-Irwin, 1990.

20

Appendix

Consider a non-collateralized portfolio of derivatives between a dealer and a counterparty. The

value today of the derivatives position to the dealer is

nd

DVA CVA f f = + (A1)

where

nd

f is the no-default value of the position and CVA and DVA are defined as follows:

17

0

CVA (1 ( )) ( ) ( )

T

c c

R t f t q t dt

+

=

}

(A2)

0

DVA (1 ( )) ( ) ( )

T

d d

R t f t q t dt

=

}

(A3)

In these equations, T is the longest maturity of the derivatives in the portfolio, ) (t f

+

is the value

today of a derivative that pays off the dealers exposure to the counterparty at time t, ) (t f

is the

value today of a derivative that pays off the counterpartys exposure to the dealer at time t ,

( )

d

q t t A is the probability of the dealer defaulting between times t and t+At, and ( )

c

q t t A is the

probability of the counterparty defaulting between times t and t+At.

18

The variables ( )

d

R t and

( )

c

R t

are the dealers and the counterpartys expected recovery rate from a default at time t. The

amount claimed on an uncollateralized derivatives exposure in the event of a default is the no-

default value. The recovery rates, ( )

d

R t and ( )

c

R t , can therefore be more precisely defined as

the percentage of no-default value of the derivatives portfolio that is recovered in the event of a

default.

The probabilities

c

q and

d

q can be estimated from the credit spreads on bonds issued by the

counterparty and the dealer. A complication is that the claim in the event of a default for a

derivatives portfolio is in many jurisdictions different from that for a bond. The credit spreads on

bonds issued must be used in conjunction with claim procedures applicable to the bonds and

17

We assume that the recovery rate, default rate, and value of the derivative are mutually independent.

18

Some adjustment for the possibility that both parties will default during the life of the derivatives portfolio may be

necessary. See, for example, Brigo and Morini (2011).

21

their expected recovery rates to estimate default probabilities. Hull and White (2000) indicate

how these calculations can be carried out.

We define the adjusted borrowing rate of a company as the borrowing rate it would have if a

zero-coupon bond issued by the company were treated in the same way as derivatives in the

event of a default. We similarly define the adjusted credit spread of a zero-coupon bond issued

by a company as the credit spread it would have if it were treated in the same way as a derivative

in the event of a default. Once default probabilities have been estimated as just described, a term

structure of adjusted credit spreads for a company can be calculated.

For convenience, we define the loss rate for the dealer as ( ) ( )(1 ( ))

d d d

L t q t R t = and the loss rate

for the counterparty as ( ) ( )(1 ( ))

c c c

L t q t R t = so that equations (A1), (A2), and (A3) become

nd

0 0

( ) ( ) ( ) ( )

T T

d c

f f f t L t dt f t L t dt

+

= +

} }

(A4)

As a first application of equation (A4) suppose that the dealer has a portfolio consisting only of a

zero-coupon bond issued by the counterparty and promising a payoff of $1 at time T. The zero-

coupon is treated like a derivative in the event of a default. In this case, 0 ) ( =

t f and

nd

) ( f t f =

+

. Furthermore

( ) T T s f f

c

) ( exp

nd

=

where ) (t s

c

is the adjusted credit spread for a zero coupon bond with maturity t issued by the

counterparty. It follows that

( ) T T s dt t L

c

T

c

) ( exp ) ( 1

0

=

}

(A5)

and

) ) ( exp( ) ) ( exp( ) (

2 2 1 1

2

1

t t s t t s dt t L

c

t

t

c c

=

}

(A6)

22

Similarly when the portfolio consists of a zero-coupon bond issued by the dealer,

nd

) ( f t f =

,

0 ) ( =

+

t f and

( ) T T s f f

d

) ( exp

nd

=

where ) (t s

d

is the adjusted credit spread for a zero coupon bond with maturity t issued by the

dealer. It follows that

( ) T T s dt t L

d

T

d

) ( exp ) ( 1

0

=

}

(A7)

and

) ) ( exp( ) ) ( exp( ) (

2 2 1 1

2

1

t t s t t s dt t L

c

t

t

c c

=

}

(A8)

There are three special cases where it is possible to use the discount rate to adjust for default risk

1. The portfolio promises a single positive payoff to the dealer (and negative payoff to the

counterparty) at time T. In this case 0 ) ( =

t f and

nd

) ( f t f =

+

so that from equation

(A4)

(

=

}

T

c

dt t L f f

0

nd

) ( 1

Using equation (A5) we obtain

( ) T T s f f

c

) ( exp

nd

=

This result shows that the derivative can be valued by using a discount rate equal to the

risk-free rate for maturity T plus s

c

(T).

2. The portfolio promises a single negative value to the dealer (and positive value to the

counterparty) at time T. In this case

nd

) ( f t f =

and 0 ) ( =

+

t f so that

23

(

=

}

T

d

dt t L f f

0

nd

) ( 1

Using equation (A7) we obtain

( ) T T s f f

d

) ( exp

nd

=

This result shows that the derivative can be valued by using a discount rate equal to the

risk-free rate for maturity T plus s

d

(T).

3. The derivatives portfolio promises a single payoff, which can be positive or negative at

time T, and the two sides have identical loss rates: L

c

(t) = L

d

(t) = L(t) for all t.

Because

nd

) ( f t f f =

+

equation (4) becomes

(

=

}

T

dt t L f f

0

nd

) ( 1

From equation (A5) or (A7) we obtain

( ) T T s f f ) ( exp

nd

=

where s(T) is the common adjusted credit spread for the dealer and the counterparty. This

result shows that the derivative can be valued by using a discount rate equal to the risk-

free rate for maturity T plus s(T).

These three cases can be generalized. A derivative promising positive payoffs to the dealer at

several different times is the sum of derivatives similar to those in 1 and can be valued using

discount rates that reflect the counterpartys adjusted borrowing rates. Similarly, a derivative

promising payoffs negative payoffs to the dealer at several different times is the sum of

derivatives similar to those in 2 and can be valued using discount rates that reflect the dealers

adjusted borrowing rates. Finally, Case 3 shows that when the two sides have identical credit

risks, any derivative can be valued by using discount rates that reflect their common adjusted

borrowing rates.

24

We now return to considering the general situation. We define ( ) L t as the loss rate at time t for

a company whose adjusted credit spread is the LIBOR-OIS credit spread. This means that,

similarly to equations (A5) to (A8)

( ) T T s dt t L

T

) ( exp ) ( 1

0

=

}

(A9)

and

) ) ( exp( ) ) ( exp( ) (

2 2 1 1

2

1

t t s t t s dt t L

t

t

=

}

(A10)

where ) (t s

If the LIBOR/swap curve defined the loss rate for both the dealer and the counterparty, equation

(A4) would show that the value of the portfolio to the dealer is given by

nd

0 0

( ) ( ) ( ) ( )

T T

f f f t L t dt f t L t dt

+

= +

} }

(A11)

From equations (A4) and (A11)

| | | |

} }

+ =

+

T

c

T

d

dt t L t L t f dt t L t L t f f f

0 0

) ( ) ( ) ( ) ( ) ( ) (

(A12)

From the extension of the third result given above we know that f is the value of the derivatives

portfolio when LIBOR/swap curve is used for discounting. It follows that we obtain correct

valuations of any derivatives portfolio if the LIBOR/swap curve is used for discounting and

CVA and DVA are calculated using loss rates for the dealer and counterparty that are the excess

of the actual loss rates over the loss rates that would apply for an entity able to borrow at

LIBOR/swap rates.

This result can be generalized. There is nothing special about the LIBOR/swap zero curve in our

analysis. Any yield curve can be used as the risk-free zero curve when a derivative is valued

providing CVA and DVA are calculated using loss rates that are the excess of the actual loss rate

over the loss rate implied by the yield curve.

25

Table 1

Value to dealer of a non-collateralized long position in a one-year forward contract to buy a non-

dividend paying stock.

Stock price = 100, delivery price =100, volatility = 30%, OIS rate = 3%, LIBOR = 3.1%, dealer

adjusted credit spread = 0.5%, counterparty adjusted credit spread = 2%

OIS LIBOR

Discounting Discounting

No-Default Value 2.955 2.952

CVA 0.187 0.178

DVA 0.032 0.026

Total 2.801 2.801

Table 2

Value to dealer of a non-collateralized long position in a one-year forward contract to buy a non-

dividend paying stock.

Stock price = 100, delivery price =100, volatility = 30%, OIS rate = 3%, LIBOR = 4.5%, dealer

adjusted credit spread = 2%, counterparty adjusted credit spread = 3%

OIS LIBOR

Discounting Discounting

No-Default Value 2.955 2.911

CVA 0.279 0.138

DVA 0.128 0.032

Total 2.805 2.805

26

Table 3

Percentage price errors in the calculated value to dealer of a non-collateralized long position in a

one-year forward contract to buy a non-dividend paying stock when LIBOR discounting is used

and LIBOR is also incorrectly used to define the growth rate in the stock price

Case 1: Stock price = 100, delivery price =100, volatility = 30%, OIS rate = 3%, LIBOR = 3.1%,

dealer adjusted credit spread = 0.5%, counterparty adjusted credit spread = 2%

Case 2: Stock price = 100, delivery price =100, volatility = 30%, OIS rate = 3%, LIBOR = 4.5%,

dealer adjusted credit spread = 2%, counterparty adjusted credit spread = 3%

Case 1 Case 2

No-Default Value 3.052 4.400

CVA 0.179 0.152

DVA 0.026 0.029

Total 2.899 4.277

Error 3.5% 52.5%

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