What is collateral discounting?

The collateral rate is the appropriate discount rate for the cash flow. In case the collateral for a transaction is remunerated in one rate and the rate for discounting the cash flow is in another, then there is a conflict leading to arbitrage opportunities.

What is discounting in derivatives?

OIS discounting is the standard methodology for valuing cash-collateralised derivatives contracts using overnight index swap rates – the rate that would be paid by the collateral receiver to the poster. Previously, Libor was used to discount all derivatives.

What is discounting risk?

A risk discount refers to a situation in which an investor is willing to accept a lower expected return in exchange for lower risk or volatility.

What is the difference between OIS and SOFR?

Note that the OIS term is not overnight; it is the underlying reference rate that is an overnight rate. … The index rate is typically the rate for overnight lending between banks, either non-secured or secured, for example the Federal funds rate or SOFR for US dollar, €STR (formerly EONIA) for Euro or SONIA for sterling.

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What does the OIS curve tell you?

OIS curves became the market standard for discounting collateralized cashflows. This curve represents the market expectations of the Federal Reserve daily target for the overnight lending rate. … As such the fed funds rate and OIS rate are the relevant funding rates for collateralized transactions.

What curve to use for discounting?

Since we now should use the OIS curve for discounting, a forecast curve for projection is still required.

Why OIS instead of LIBOR?

The major reason for switching from using LIBOR to the OIS as a term structure for pricing interest rate swaps is that OIS discounting better reflects the counterparty credit risk in a collateralized interest rate swap. … Due to these developments/ requirements, the credit risk on swaps has reduced significantly.

What you mean by discounting?

Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future. Given the time value of money, a dollar is worth more today than it would be worth tomorrow.

What is discount rate in NPV?

The discount rate will be company-specific as it’s related to how the company gets its funds. It’s the rate of return that the investors expect or the cost of borrowing money. If shareholders expect a 12% return, that is the discount rate the company will use to calculate NPV.

How is discount factor calculated?

For example, to calculate discount factor for a cash flow one year in the future, you could simply divide 1 by the interest rate plus 1. For an interest rate of 5%, the discount factor would be 1 divided by 1.05, or 95%.

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What is 3m LIBOR?

3-month LIBOR Rate means the rate for deposits in U.S. dollars for the 3-month period commencing on the applicable Interest Payment Date which appears on Telerate Page 3750 at approximately 11:00 a.m., London time, on the second London banking day prior to the applicable Interest Payment Date.

How does a swap work?

A swap is an agreement for a financial exchange in which one of the two parties promises to make, with an established frequency, a series of payments, in exchange for receiving another set of payments from the other party. These flows normally respond to interest payments based on the nominal amount of the swap.

What is the difference between LIBOR and SOFR?

The main difference between SOFR and LIBOR is how the rates are produced. While LIBOR is based on panel bank input, SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo) market.

Why LIBOR is unsecured?

Additionally, Patel points out, Libor is unsecured—the lending it’s based on doesn’t use collateral—so it includes a credit risk premium. SOFR is a secured rate, based on transactions that involve collateral, in the form of Treasuries, so there’s no credit risk premium baked into the rates.

What is a collateralized swap?

“Collateralization” of a swap transaction refers to a situation where either or both parties to a swap are required to offer security or credit support for the risk that their counterparty is taking on the transaction at any given point in time.

What is overnight LIBOR?

Overnight LIBOR means at any time the rate of interest equal to LIBOR then in effect for an overnight period. … Overnight LIBOR means the London Inter Bank Offered Rate which is fixed on a daily basis by the British Bankers’ Association, which applies for deposits held overnight.

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