OIS Discounting, Multi-Curve Frameworks, and the SOFR Transition

Until 2008, the standard practice for pricing interest-rate derivatives was to use a single yield curve: the LIBOR/swap curve served both to project forward rates (what LIBOR would be paid on the floating leg) and to discount future cash flows (what those payments are worth today). The financial crisis revealed that LIBOR carried substantial bank credit risk — the spread between LIBOR and overnight indexed swap (OIS) rates, which had been near zero before 2008, widened to over 350 basis points at the peak. Since a derivative collateralised under an ISDA/CSA agreement earns OIS on the collateral (not LIBOR), the correct discount rate for cleared or collateralised derivatives is OIS, not LIBOR. This created the multi-curve framework: separate curves for projection (forward rate) and discounting (OIS). The LIBOR cessation (2021–2023) and the transition to SOFR (Secured Overnight Financing Rate) extended this framework while eliminating the bank-credit component from the reference rate entirely.