Financial instruments such as interest rate swaps, futures contracts, variable rate mortgages and syndicated loans extensively use the LIBOR as a reference rate. LIBOR is actually an acronym for London InterBank Offered Rate. The British Bankers Association publish LIBOR at 11:00 AM (London time) each day together with Thomson Reuters. This is basically a day-to-day reference rate centered on the interest rates at which banks in the wholesale money market in London lend out unsecured funds to other banks. These lenders will usually add a couple of points to generate a profit.
LIBOR is typically a few tenths of a point above the current Federal Reserve Funds rate (the Federal Reserve employs this rate to regulate how much banks lend) which ranges from zero to a quarter percent.
The LIBOR rate is defined as follows. It is the interest rate which banks must pay in order to borrow via the London Interbank Market. These contributions have to signify rates established in London and nowhere else. Moreover, the contributions must be for the currency being used, not the cost of obtaining one currency by borrowing in a different currency and retrieving the needed currency through the foreign exchange markets.
Another requirement is that the rates should be given by bank staff members with their key duty being that they are involved in the bank’s cash management, rather than the derivative book of a bank. There is also a definition of the “funds” that have been talked about in this article and it is the cash acquired through principal issuance of interbank Certificates of Deposit.
It is important that you check your mortgage to find out how it is constructed on the LIBOR rate as this has significant implications. The rate will reset based on the LIBOR rate in the case of an adjustable-rate loan. A climbing LIBOR rate will make all kinds of business loans and consumer borrowing more costly and this applies even if an individual has a fixed-rate loan and they settle their credit card balances in full every month. Overall, liquidity will fall, economic growth slows down and there will be a rise in the unemployment rate.
The LIBOR is estimated for ten currencies. Additionally, there can be eight, twelve, sixteen or twenty contributor banks on each currency board, and the stated interest rate is the average of the fifty percent middle values which is referred to as the interquartile mean. It is vital to note here that the rates are a yardstick rather than an actual tradable rate. Interestingly, the real rate at which banks will lend to other banks tends to fluctuate during the course of the day.
The US dollar, Euro, Swiss franc, Canadian dollar, Japanese yen, Australian dollar and Swedish krona make use of the LIBOR as a rate of reference. The Chicago Mercantile Exchange’s Eurodollar contracts are the most profoundly traded short term interest rate futures contracts in the world and are constructed on quarterly LIBOR rates based on the US dollar.
In the interest rate swap market, the five year swap rate is denoted as the “five year LIBOR” rate where the ‘floating leg’ of the swap indicates either three or six month LIBOR rates. When referring to a bond, “LIBOR + x basis points”, signifies that the cash flows of the bond have to be discounted on the swaps’ zero-coupon yield curve shifted by x basis points for it to match the real market price of the bond.
In October 2008 the International Monetary Fund circulated its semiannual report which stated that even though the reliability of the fixing mechanism of the U.S. dollar LIBOR has been challenged by a the financial media and a few participants in the market, it is still the U.S. dollar LIBOR that is a precise estimate of the marginal cost of a financially responsible bank when it needs to obtain unsecured U.S. dollar term monetary resources.