LIBOR vs. OIS: The Derivatives Discounting Dilemma

LIBOR vs. OIS: The Derivatives Discounting Dilemma

Traditionally practitioners have used LIBOR and LIBOR swap rates as proxies for risk-free rates when valuing derivatives. This practice has been called into question by the credit crisis that started in 2007.
Derivatives dealers have traditionally used LIBOR and LIBOR swap rates as proxies for the risk-free rate.1 They calculate a risk-free zero curve using LIBOR rates, Eurodollar futures rates, and swap rates. LIBOR rates can be regarded as the short-term borrowing rates of AA-rated financial institutions.
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Federal funds are balances held at Federal Reserve Banks. Most large North American depository institutions and many large European and Asian financial institutions maintain accounts at the Reserve banks. Fedwire is the name given to the real time wire transfer system run by the Federal Reserve. Institutions that maintain accounts at the Reserve banks have access to Fedwire and use it to make payments by transferring deposits from their account to the accounts of other institutions at the Reserve Banks. Every transaction over Fedwire is immediately debited to the paying bank’s account and credited to the receiving bank’s account. The payments may be related to the purchase and sale of securities, bank loans, other commercial transactions, and federal funds loans. Approximately 500,000 transactions per day with a total value of $2.7 trillion per day were processed in the second quarter of 2011.
The credit crisis showed that LIBOR and LIBOR swap rates can incorporate significant risk premia when markets are stressed.

http://www.rotman.utoronto.ca/~hull/DownloadablePublications/LIBORvsOIS.pdf