OIS Discounting, Interest Rate Derivatives, and the Modeling of Stochastic Interest Rate Spreads

Forthcoming in Journal of Investment Management

Rotman School of Management Working Paper No. 2359610

38 Pages Posted: 27 Nov 2013 Last revised: 18 Sep 2014

See all articles by John C. Hull

John C. Hull

University of Toronto - Rotman School of Management

Alan White

University of Toronto - Rotman School of Management

Date Written: March 1, 2014

Abstract

Prior to 2007, derivatives practitioners used a zero curve that was bootstrapped from LIBOR swap rates to provide “risk-free” rates when pricing derivatives. In the last few years, when pricing fully collateralized transactions, practitioners have switched to using a zero curve bootstrapped from overnight indexed swap (OIS) rates for discounting. This paper explains the calculations underlying the use of OIS rates and investigates the impact of the switch on the pricing of plain vanilla caps and swap options. It also explores how more complex derivatives providing payoffs dependent on LIBOR, or any other reference rate, can be valued. It presents new results showing that they can be handled by constructing a single tree for the evolution of the OIS rate.

Keywords: OIS, LIBOR, Swaps, Swaptions, Caps, Interest Rate Trees

JEL Classification: G21, G33

Suggested Citation

Hull, John C. and White, Alan, OIS Discounting, Interest Rate Derivatives, and the Modeling of Stochastic Interest Rate Spreads (March 1, 2014). Forthcoming in Journal of Investment Management; Rotman School of Management Working Paper No. 2359610. Available at SSRN: https://ssrn.com/abstract=2359610 or http://dx.doi.org/10.2139/ssrn.2359610

John C. Hull (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
(416) 978-8615 (Phone)
416-971-3048 (Fax)

Alan White

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-978-3689 (Phone)
416-971-3048 (Fax)

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