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LIBOR vs. OIS: The Derivatives Discounting Dilemma



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.

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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.
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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.
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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.
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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).
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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.
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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.
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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.
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Major brokers report the dollar amount
loaned at each interest rate to the New York Federal Reserve Bank of New York (FRBNY)
daily.
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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.
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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.
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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.
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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

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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).
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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.
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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.
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quality banks.
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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.
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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

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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).
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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
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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.
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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

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Legislation requiring standard swaps to be cleared centrally means that swap quotes are likely to reflect
collateralized transactions in the future.
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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
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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.
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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.

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The collateral available typically depends on the value of the portfolio several days earlier when the counterparty
is assumed to stop paying collateral.
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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.
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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;

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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.
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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.
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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.
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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

is the zero-coupon LIBOR-OIS spread for maturity t.


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%