Theoretically, in pricing derivatives, most textbooks refer to the risk-free rate. What is obtainable in practice? The risk-free rate or the LIBOR rate?
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Before 2007, LIBOR was commonly used for risk-free rate. It was a good proxy because it was quite close to the OIS rates. Since 2007, the LIBOR–OIS spread has spiked and became unstable. Therefore, LIBOR is no longer a good proxy for discounting. Nowadays, Banks usually use OIS for modelling.
Read the wikipedia article on OIS-LIBOR spread. John Hull has a very popular paper on the subject.
answered Jul 26, 2016 at 12:51
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1$\begingroup$ John Hull said: "Most derivatives dealers now use interest rates based on overnight indexed swap (OIS) rates rather than LIBOR when valuing collateralized derivatives. For non-collateralized transactions, most dealers continue to use LIBOR rates for valuation." $\endgroup$– nbbo2Commented Jul 26, 2016 at 12:57
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$\begingroup$ I was actually concerned about adding a risk premium to the risk-free rate vs using a risk-free rate directly in fx futures pricing. $\endgroup$ Commented Jul 26, 2016 at 15:20
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$\begingroup$ @AkinyinkaAkintunde If you add a risk premium, then it's not a risk-free rate anymore? $\endgroup$ Commented Jul 26, 2016 at 15:44
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$\begingroup$ @Student T Yes, it will no longer be risk-free. but will that be appropriate in pricing forwards? $\endgroup$ Commented Jul 28, 2016 at 16:50
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$\begingroup$ @AkinyinkaAkintunde I think you should start a new question, so other people can join (not just you and me) $\endgroup$ Commented Jul 28, 2016 at 16:51