What is the difference between OIS discounting and Libor discounting, and why did markets shift?

• A. OIS discounting uses collateralized overnight rate; Libor includes credit risk; markets moved to OIS after 2008 for risk-free valuation.
• B. OIS uses long-term rate; Libor uses overnight; markets moved due to regulation.
• C. OIS is less volatile; Libor is risk-free; moved due to liquidity.
• D. OIS and Libor are the same.

Answer: (A)

Discounting derivatives hinges on what funding cost and counterparty risk you’re assuming for future cash flows. OIS discounting uses the collateralized overnight rate from overnight indexed swaps, which tracks near risk-free funding costs because collateral mitigates credit risk. Libor discounting uses the unsecured interbank rate, which embeds a credit risk premium and funding liquidity concerns. After the 2008 crisis, markets shifted to OIS-based discounting for collateralized trades to reflect a true risk-free valuation under collateral terms and to align pricing with actual funding costs. This move, driven by regulatory reforms and evolving market practice, aimed to separate credit risk from discounting. The other statements misstate the nature of the rates—OIS is not a long-term rate, and Libor is not risk-free—and therefore don’t fit the real distinction.