The London Interbank Offered Rate (or LIBOR, pronounced /ˈlaɪbɔr/) is a daily reference rate A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate. Parties to the contract choose a reference rate that neither party based on the interest rates An interest rate is the price a borrower pays for the use of money they do not own, for instance a small company might borrow from a bank to kick start their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interest rates are normally expressed as a percentage rate over the period of one at which banks A bank is a financial institution licensed by a government. Its primary activities include borrowing and lending money. Many other financial activities were allowed over time. For example banks are important players in financial markets and offer financial services such as investment funds. In some countries such as Germany, banks have borrow unsecured An unsecured loan is a loan that is not backed by collateral. Also known as a signature loan or personal loan funds from other banks in the London wholesale money market In finance, the money market is the global financial market for short-term borrowing and lending. It provides short-term liquidity funding for the global financial system. The money market is where short-term obligations such as Treasury bills, commercial paper and bankers' acceptances are bought and sold (or interbank market The interbank market is the top-level foreign exchange market where banks exchange different currencies. The banks can either deal with one another directly, or through electronic brokering platforms. The Electronic Brokering Services and Reuters Dealing 3000 Matching are the two competitors in the electronic brokering platform business and). It is roughly comparable to the U.S. Federal funds In the United States, federal funds are overnight borrowings by banks to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. Transactions in the federal funds market enable depository institutions with reserve balances in excess of rate In the United States, the federal funds rate is the interest rate at which private depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans. Changing the target rate is one way the Chairman of the Federal Reserve can.

Contents

Introduction

During 1958 it became apparent that an increasing number of banks were trading actively in a variety of relatively new market instruments, notably interest rate swaps An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest, foreign currency options In finance, a foreign exchange option is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date and forward rate agreements In finance, a forward rate agreement is a forward contract in which one party pays a fixed interest rate, and receives a floating interest rate equal to a reference rate (the underlying rate). The payments are calculated over a notional amount over a certain period, and netted, i.e. only the differential is paid. It is paid on the effective date. Whilst recognizing that such instruments brought more business and greater depth to the London Interbank market, it was felt that future growth could be inhibited unless a measure of uniformity was introduced. In October 1984 the British Bankers' Association Banks from more than sixty nations are represented among its two hundred members. The members collectively operate 130 million personal accounts, have over £6 trillion of assets, are the fastest growing sector in the UK, have created jobs either directly or indirectly for four million people, contribute £50 billion to the UK economy and last working with other parties such as the Bank of England The Bank of England is the central bank of the United Kingdom and is the model on which most modern, large central banks have been based. Since 1946 it has been a state-owned institution. It was established in 1694 to act as the English Government's banker, and to this day it still acts as the banker for the UK Government. The Bank has a monopoly established various working parties, which eventually culminated in the production of the BBAIRS terms – the BBA standard for interest swap rates. Part of this standard included the fixing of BBA interest settlement rates, the predecessor of BBA LIBOR. From 2 September 1985 the BBAIRS terms became standard market practice.

BBA LIBOR fixings did not commence officially before 1 January 1986, although before that some rates have been fixed for a trial period commencing in December 1984.

It should be noted that member banks Banks from more than sixty nations are represented among its two hundred members. The members collectively operate 130 million personal accounts, have over £6 trillion of assets, are the fastest growing sector in the UK, have created jobs either directly or indirectly for four million people, contribute £50 billion to the UK economy and last are international in scope, with more than sixty nations represented among its 223 members and 37 associated professional firms (as of 2008).

Scope

LIBOR rates are widely used as a reference rate for financial instruments such as:

They thus provide the basis for some of the world's most liquid and active interest rate markets.

For the Euro The euro is the official currency of 16 of the 27 member states of the European Union (EU). The states, known collectively as the Eurozone, are Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. The currency is also used in a further five European, however, the usual reference rates are the Euribor The Euro Interbank Offered Rate is a daily reference rate based on the averaged interest rates at which banks offer to lend unsecured funds to other banks in the euro wholesale money market (or interbank market) rates compiled by the European Banking Federation, from a larger bank panel. A Euro LIBOR does exist, but mainly for continuity purposes in swap contracts dating back to pre-EMU A monetary union is a situation where several countries have agreed to share a single currency amongst themselves. The European Economic and Monetary Union consists of three stages coordinating economic policy and culminating with the adoption of the euro, the EU's single currency. All member states of the European Union are expected to times. LIBOR is just an estimate and not interred in the legally binding contracts of an LLC

Technical features

LIBOR is calculated by Thomson Reuters Thomson Reuters is an information company created by the Thomson Corporation's purchase of Reuters on 17 April 2008. It is a dual listed company with two parent companies: Thomson Reuters plc is a British company and a constituent of the FTSE 100 Index, and Thomson Reuters Corporation is a Canadian company and a constituent of the S&P/TSX 60 and published by the British Bankers' Association Banks from more than sixty nations are represented among its two hundred members. The members collectively operate 130 million personal accounts, have over £6 trillion of assets, are the fastest growing sector in the UK, have created jobs either directly or indirectly for four million people, contribute £50 billion to the UK economy and last (BBA) after 11:00 am (and generally around 11:45 am) each day (London time). It is a trimmed average of inter-bank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. LIBOR is calculated for 10 currencies. There are either eight, twelve or sixteen contributor banks on each currency panel and the reported interest is the mean of the middle values (the interquartile mean). The rates are a benchmark rather than a tradable rate, the actual rate at which banks will lend to one another continues to vary throughout the day.

GBP LIBOR is often used as a rate of reference for Pound Sterling The pound sterling , often simply called the pound, is the currency of the United Kingdom, its Crown dependencies (the Isle of Man and the Channel Islands) and the British Overseas Territories of South Georgia and the South Sandwich Islands and British Antarctic Territory. It is subdivided into 100 pence (singular: penny) and other currencies, including US dollar The United States dollar is the unit of currency of the United States The U.S. dollar is normally abbreviated as the dollar sign, $, or as USD or US$ to distinguish it from other dollar-denominated currencies and from others that use the $ symbol. It is divided into 100 cents (200 half-cents prior to 1857), Euro The euro is the official currency of 16 of the 27 member states of the European Union (EU). The states, known collectively as the Eurozone, are Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. The currency is also used in a further five European, Japanese Yen The yen (sign: ¥; code: JPY) is the currency of Japan. It is the third most-traded currency in the foreign exchange market after United States dollar and the euro. It is also widely used as a reserve currency after the U.S. dollar, the euro and the pound sterling. As is common when counting in East Asia, large quantities of yen are often counted, Swiss Franc The franc is the currency and legal tender of Switzerland and Liechtenstein; it is also legal tender in the Italian exclave Campione d'Italia. Although not formally legal tender in the German exclave Büsingen (the sole legal currency is the euro), it is widely used on a day-to-day basis. The Swiss National Bank issues banknotes and the federal, Canadian dollar The Canadian dollar is the currency of Canada. It is normally abbreviated with the dollar sign $, or C$ to distinguish it from other dollar-denominated currencies. It is divided into 100 cents. As of 2007, the Canadian dollar was the 7th most traded currency in the world, Australian Dollar The Australian dollar is the currency of the Commonwealth of Australia, including Christmas Island, Cocos (Keeling) Islands, and Norfolk Island, as well as the independent Pacific Island states of Kiribati, Nauru and Tuvalu. Within Australia it is almost always abbreviated with the dollar sign ($), with A$ or AU$ sometimes used informally to, Swedish Krona The krona has been the currency of Sweden since 1873. It is locally abbreviated kr. The plural form is kronor and one krona is subdivided into 100 öre (singular and plural). The currency is sometimes informally referred to as the "Swedish crown" in English (since krona literally means crown in Swedish). The Swedish krona also circulates, Danish Krone The krone is the currency of Denmark, including the autonomous provinces of Greenland and the Faroe Islands. The krone is pegged to the euro via the European Union's exchange rate mechanism. The plural form is "kroner" and one krone is divided into 100 øre, the singular form being the same as the plural. The ISO 4217 code is DKK; the and New Zealand dollar The New Zealand dollar is the currency of New Zealand. It also circulates in the Cook Islands (see also Cook Islands dollar), Niue, Tokelau, and the Pitcairn Islands. It is divided into 100 cents.[2]

In the 1990s, Yen LIBOR rates were influenced by credit problems affecting some of the contributor banks.

For a precise definition of BBA LIBOR, see: The BBA LIBOR fixing & definition.

Six-month USD LIBOR is used as an index for some US mortgages An adjustable rate mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices. Among the most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost. In the UK, the three-month GBP LIBOR is used for some mortgages A variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate varies to reflect market conditions—especially for those with adverse credit history.

Definition of LIBOR

LIBOR is defined as:

"The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time."

This definition is amplified as follows:-

LIBOR-based derivatives

Eurodollar contracts

The Chicago Mercantile Exchange The Chicago Mercantile Exchange (often called "the Chicago Merc," or "the Merc") is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization. The exchange demutualized in November 2000, went's Eurodollar Eurodollars are deposits denominated in US dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the United States, allowing for higher margins. There is nothing "European" about Eurodollar contracts are based on three-month US dollar LIBOR rates. They are the world's most heavily traded short term interest rate futures contracts and extend up to ten years. Shorter maturities trade on the Singapore Exchange Singapore Exchange Limited SGX: S68 is the stock exchange in Singapore. SGX was formed on December 1, 1999, following the merger of two established and well-respected financial institutions - the Stock Exchange of Singapore (SES) and the Singapore International Monetary Exchange (SIMEX). It is the Asia-Pacific's first demutualised and integrated in Asian time. (M. Tanveer Ahmed)

Interest rate swaps

Interest rate swaps based on short LIBOR rates currently trade on the interbank market The interbank market is the top-level foreign exchange market where banks exchange different currencies. The banks can either deal with one another directly, or through electronic brokering platforms. The Electronic Brokering Services and Reuters Dealing 3000 Matching are the two competitors in the electronic brokering platform business and for maturities up to 50 years. A "five year LIBOR" rate refers to the 5 year swap rate vs 3 or 6 month LIBOR. "LIBOR + x basis points A basis point is a unit that is equal to 1/100th of a percentage point. It is frequently used to express percentage point changes of less than 1%. It avoids the ambiguity between relative and absolute discussions about rates. For example, a "1% increase" in a 10% interest rate could mean an increase from 10% to 10.1% (relative), or from 1", when talking about a bond, means that the bond's cash flows have to be discounted on the swaps' zero-coupon yield curve In finance, the yield curve is the relation between the interest rate and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one on shifted by x basis points in order to equal the bond's actual market price. The day count convention In finance, a day count convention determines how interest accrues over time for a variety of investments, including bonds, notes, loans, medium-term notes, swaps, and FRAs. This includes the amount transferred on interest payment dates, but also the calculation of accrued interest for dates between payments. When a security such as a bond is sold for LIBOR rates in interest rate swaps is Actual/360.

Reliability

On Thursday, 29 May 2008 the Wall Street Journal The Wall Street Journal is an English-language international daily newspaper published by Dow Jones & Company, a division of News Corporation, in New York City, with Asian and European editions. As of 2007, it has a worldwide daily circulation of more than 2 million, with approximately 931,000 paying online subscribers. It was the largest- released a controversial study suggesting that banks may have understated borrowing costs they reported for LIBOR during the 2008 credit crunch.[3] Such underreporting could have created an impression that banks could borrow from other banks more cheaply than they could in reality. It could also have made the banking system appear healthier than it was during the 2008 credit crunch.

For example, the study found that rates at which one major bank "said it could borrow dollars for three months were about 0.87 percentage point lower than the rate calculated using default-insurance data."

In response to the study released by the WSJ, the British Bankers' Association announced that LIBOR continues to be reliable even in times of financial crisis. According to the British Bankers' Association, other proxies for financial health such as the default credit insurance market, are not necessarily more sound than LIBOR at times of financial crisis, though more widely used in Latin America, especially the Ecuadorian and Bolivian markets.

Additionally, other authorities have contradicted the Wall Street Journal article. In their March 2008 Quarterly Review The Bank for International Settlements The Bank for International Settlements is an international organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government. The BIS carries out its work through subcommittees, the secretariats it hosts, and through its have stated that "available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings". Further, In October 2008 the International Monetary Fund published their regular Global Financial Stability Review which also found that "Although the integrity of the U.S. dollar LIBOR fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar LIBOR remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding"

See also

References

  1. ^ What Is a Libor Mortgage?
  2. ^ www.bba.org.uk
  3. ^ "Study Casts Doubt on Key Rate - WSJ.com". http://online.wsj.com/article/SB121200703762027135.html?mod=MKTW.

Further reading

External links

Categories: Interest rates | Economics terminology | Terms and concepts of the 2000s United States housing bubble

 

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