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FRM Part I · FRM Exam Part I · Swaps

A dealer values a fully collateralized interest rate swap, with cash collateral that earns the overnight rate. Which discount curve is generally regarded as appropriate for the swap's cash flows?

The OIS curve is the appropriate discount curve for collateralized swaps, because the collateral earns the overnight rate and so the effective funding cost is close to risk-free. Term LIBOR includes bank credit and liquidity premia that are irrelevant when exposure is fully collateralized.

  1. AThe curve derived from overnight indexed swap (OIS) ratesCorrect
  2. BThe issuer's own corporate bond yield curve
  3. CThe Treasury par yield curve with a liquidity premium added
  4. DThe term LIBOR curve matched to each payment date

Explanation

For collateralized derivatives, the funding rate is effectively the rate paid on collateral, which is the overnight rate. Hence OIS-based discounting is the standard choice. Term LIBOR embeds bank credit and liquidity premia that do not apply to collateralized exposures.

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