FRM Part I · FRM Exam Part I · Swaps
A dealer values a fully collateralized interest rate swap using current market practice. Which discount curve is the standard choice for discounting the swap's cash flows?
The standard discount curve is the one built from overnight indexed swap rates. Collateral posted against a swap earns roughly the overnight rate, so OIS is the best proxy for the risk-free rate. Curves reflecting unsecured credit or funding spreads do not match the collateral economics.
- AA curve built from overnight indexed swap (OIS) rates, which approximates the collateral rateCorrect
- BThe dealer's own unsecured bond yield curve
- CA curve built from the swap's fixed rate
- DThe yield curve on the lowest-rated counterparty's debt
Explanation
For collateralized derivatives, the cash posted as collateral earns approximately the overnight rate, so the appropriate discount rate is the OIS rate, regarded as the best proxy for the risk-free rate. The other curves embed credit or funding spreads, or are circular, and do not match the collateral remuneration.
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