London Interbank Offered Rate

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The London Interbank Offered Rate (or LIBOR, pronounced /ˈlaɪbɔr/) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). LIBOR will be slightly higher than the London Interbank Bid Rate (LIBID), the rate at which banks are prepared to accept deposits.

Contents

[edit] Introduction

During 1984 it became apparent that an increasing number of banks were trading actively in a variety of relatively new market instruments, notably Interest Rate Swaps, Foreign Currency Options and Forward Rate Agreements. 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 working with other parties such as the Bank of England 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.

[edit] 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, however, the usual reference rates are the Euribor 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 times.

[edit] Technical features

LIBOR is published by the British Bankers' Association (BBA) after 11:00 am (and generally around 11:45 am) each day, London time, and is a filtered average of inter-bank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. There are 16 such contributor banks and the reported interest is the mean of the 8 middle values. The shorter rates, i.e., up to 6 months, are usually quite reliable and tend to precisely reflect market conditions. The actual rate at which banks will lend to one another will, however, continue to vary throughout the day.

LIBOR is often used as a rate of reference for Pound Sterling and other currencies, including US dollar, Euro, Japanese Yen, Swiss Franc, Canadian dollar, Australian Dollar, Swedish Krona, Danish Krone and New Zealand dollar[1].

In the 1990s, Yen LIBOR rates were altered by credit problems affecting some, but not all, of the contributor banks.

For a precise definition of BBA LIBOR, see the BBA website.

Six-month LIBOR is used as an index for some US mortgages. In the UK, the 3 month LIBOR is used for some mortgages especially for those with adverse credit history.

[edit] LIBOR-based derivatives

[edit] Eurodollar contracts

The Chicago Mercantile Exchange's 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 10 years. Shorter maturities trade on the Singapore Exchange in Asian time.

[edit] Interest Rate Swaps

Interest rate swaps based on short LIBOR rates currently trade on the interbank market 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", when talking about a bond, means that the bond's cash flows have to be discounted on the swaps' zero-coupon yield curve shifted by x basis points in order to equal the bond's actual market price. The day count convention for LIBOR rates in interest rate swaps is Actual/360.

[edit] Reliability

On Thursday, May 29, 2008 the Wall Street Journal released a study suggesting that banks may have understated borrowing costs they reported for LIBOR during the 2008 credit crunch. 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.

[edit] References

  1. ^ www.bba.org.uk

[edit] See also

[edit] Bibliography

  • Carrick Mollenkamp and Mark Whitehouse, Study Casts Doubt on Key Rate: WSJ Analysis Suggests Banks May Have Reported Flawed Interest Data for Libor (The Wall Street Journal, Thursday, May 29th, 2008, page 1)

[edit] External links