An interest rate swap is an agreement between two parties to exchange future interest-related cash flows. It can be interpreted either as an exchange of a fixed-rate coupon bond for a floating-rate coupon bond or as a portfolio of forward rate agreements. The valuation of interest rate swaps is based on discounting future cash flows. The traditional approach uses discount factors corresponding to the term structure of the reference interest rate underlying the swap, such as Euribor.This approach is appropriate when the risk profile of the swap cash flows is consistent with that of the unsecured interbank lending transactions underlying the reference interest rate.
For the valuation of collateralized interest rate swaps, discounting based on Overnight Indexed Swap (OIS) rates is used. Under this approach, future cash flows are discounted using interest rates derived from fixed rates of OIS contracts. Unlike discounting based on Euribor rates, the OIS discounting approach appropriately removes credit and liquidity risk, which are minimized for collateralized swaps.
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