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.

| improve this answer | |
  • 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." $\endgroup$ – 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? $\endgroup$ – HelloWorld 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) $\endgroup$ – HelloWorld Jul 28 '16 at 16:51

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.