Understanding LIBOR
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans. LIBOR is considered one of the most influential interest rates in the financial markets, impacting trillions of dollars’ worth of financial products worldwide.
Detailed Definition
LIBOR is calculated for five currencies (the U.S. dollar, euro, British pound, Japanese yen, and Swiss franc) and is published in several maturities, ranging from overnight to one year. It serves as an index for setting interest rates on various adjustable-rate financial products, such as mortgages, corporate loans, derivatives, and other financial instruments.
Calculation Process
Every day, the Intercontinental Exchange (ICE) collects and compiles interest rates from a panel of major global banks. These banks submit the interest rates at which they would lend to each other for different durations and in different currencies. The highest and lowest data points are eliminated, and the remaining rates are averaged to determine the LIBOR for each currency and maturity.
Examples
- Mortgage Loans: A U.S. homeowner takes out an adjustable-rate mortgage tied to LIBOR. The homeowner’s interest rate is set at LIBOR plus 2%. If LIBOR is 1%, the homeowner will pay an interest rate of 3%.
- Corporate Loan: A multinational company secures a line of credit from a bank, where the interest rate on the loan is set at LIBOR plus 1.5%. This helps the company manage its borrowing costs in relation to global interest rate movements.
- Derivatives: Hedge funds and financial institutions use interest rate swaps pegged to LIBOR to manage and hedge interest rate risk exposure.
Frequently Asked Questions
What is LIBOR used for?
LIBOR is used as a reference rate for setting the interest prices of numerous financial products ranging from mortgages and student loans to bonds and derivatives.
How often is LIBOR updated?
LIBOR is updated daily for various maturities in the five major currencies: USD, EUR, GBP, JPY, and CHF.
Why is LIBOR being phased out?
Due to concerns over manipulation and the desire for a more transparent and reliable rate-setting process, LIBOR is being phased out and replaced by alternative rates like the Secured Overnight Financing Rate (SOFR) in the U.S. by the end of 2021.
How does LIBOR impact adjustable-rate mortgages (ARMs)?
For ARMs linked to LIBOR, the interest rate on the mortgage will reset periodically based on the current LIBOR rate plus a predetermined margin. Thus, changes in LIBOR directly affect the monthly mortgage payments.
Related Terms with Definitions
- Eurodollars: U.S. dollars held in banks outside the United States. These deposits are used for international trade and investment.
- SOFR (Secured Overnight Financing Rate): An alternative benchmark interest rate selected to replace USD LIBOR. It represents the cost of borrowing cash overnight, collateralized by Treasury securities.
- Interbank Market: A network of banks dealing directly with each other in over-the-counter financial markets, typically for short-term loans and deposits.
Online Resources
- ICE LIBOR Official Website
- Federal Reserve Alternative Reference Rates Committee
- Investopedia on LIBOR
References
- “The LIBOR Scandal: A Reader’s Guide,” The New York Times, accessed here.
- “LIBOR Transition FAQ,” Federal Reserve Bank of New York, accessed here.
Suggested Books for Further Studies
- “Priceless: The Myth of Fair Value (and How to Take Advantage of It)” by William Poundstone - Offers insights into various financial benchmarks, including LIBOR.
- “The Volatility Smile” by Emanuel Derman - Provides deeper understanding of financial markets and interest rates used for benchmarks like LIBOR.
- “Financial Risk Manager Handbook” by Philippe Jorion - Essential reading for understanding various financial risks and the role of benchmarks.
