I was very impressed by reading an article in the Internet about OIS and LIBOR rates that are used to value swap trades.
Clearly stated, simple Interest Rate Swaps can be valued using different approaches to interest rates. Commonly used Libor is the market indicator but it seems like big institutionals used to have OIS as a discounting rate instead of Libor.
Using Libor rather than OIS to discount $10 million notional IRS can result in a difference of around $200 000 on a trade!
If higher Libor used the NPV is lower of cause, if lower OIS rate is used the NPV is higher. Tricky enough to value Interest rate instruments by shifting money along the curve and monetise trades to unwind negative ones or call more collaterals from clients.
The one more thing to say is that a client always must ensure an institutional about its own creditworthiness posting premium as collateral while institutionals always make profit by keeping premium in house till the expiration date.
Credit crunch 2008 changed a traditional way to value derivatives and proposed to include some specific terms like CVA/DVA to reflect credit and liquidity risk, funding costs.
Collateral managment changed as well.
When applying the Libor rate, all of the terms above were actually ignored, therefore the Libor rate is no longer considered to be a risk-free rate, mainly due to the LIBOR-OIS spread.
The LIBOR and OIS curves had a very high correlation. After september 2008, Libor diverged significantly from OIS and the spread widened.
OIS USD rates reflect the FED Fund rate that paid on collateral ammount and theoretically should be used as a discounting rate.
After 2011, when ISDA employed OIS discounting, it has been a standard on the market taking into account applicable risks like credit risk.
But not all market participants are ready to switch to the new methodology, even if it seems to be correct.
A lesson to learn is: Everyone may value OTC derivative contracts in a way it is profitable.