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?


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.

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    $\begingroup$ 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." $\endgroup$ – noob2 Jul 26 '16 at 12:57
  • $\begingroup$ 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. $\endgroup$ – Akinyinka Akintunde Jul 26 '16 at 15:20
  • $\begingroup$ @AkinyinkaAkintunde If you add a risk premium, then it's not a risk-free rate anymore? $\endgroup$ – SmallChess Jul 26 '16 at 15:44
  • $\begingroup$ @Student T Yes, it will no longer be risk-free. but will that be appropriate in pricing forwards? $\endgroup$ – Akinyinka Akintunde Jul 28 '16 at 16:50
  • $\begingroup$ @AkinyinkaAkintunde I think you should start a new question, so other people can join (not just you and me) $\endgroup$ – SmallChess Jul 28 '16 at 16:51

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