Recent news reports of LIBOR fixing have people talking about the integrity of the financial system, and whether similar actions might have caused the financial crisis. But what exactly is LIBOR, and why is it important?
LIBOR, or the London Interbank Offer Rate, is basically the interest rate at which major London banks are willing to lend to other major London banks for short-term unsecured money (i.e., loans to be repaid in one year or less). There are actually many LIBOR rates quoted simultaneously for different currencies and maturities ranging from one day (overnight) to one year. The most commonly quoted LIBOR rates are for U.S. dollar borrowings at 3-, 6-, and 12-month maturities.
LIBOR is important because its value influences the interest rates and market price of an enormous range of securities. LIBOR is designed to be an industry-standard reference rate for short-term borrowing costs that can be used to value securities linked to short-term interest rates. These include floating rate bonds, mortgages, swaps, forward rate agreements, interest rate options and futures, and other products. In addition, LIBOR may indirectly affect the price of non-interest rate products such as stocks, real estate, and commodities.
As an example, a floating rate bond might be quoted as paying 6-month LIBOR + 2%. What this means is that at specific dates determined in the bond contract, the interest due on the bond will be set to whatever the 6-month LIBOR is at that time, plus 2%. If the 6-month LIBOR is 3.5% on the stated date, then the floating bond will deliver 3.5% + 2%, or 5.5%, on its next coupon payment (or half of that, if it is a semi-annual payment). An interest rate swap might take this a step further and promise to exchange payments of, say, 6-month LIBOR + 3% for an unchanging (i.e., fixed) payment of 5% over a set period of time.
When LIBOR changes, the payments received and due across a whole range of products change with it, so LIBOR is fairly influential.
History and Calculation
LIBOR was created in 1984 to give banks and other financial institutions a single industry-wide number that financial participants can agree on as representing the current state of short-term interest rates at different maturities. An increase in the number of products (swaps, forward rate agreements, interest rate options, etc.) that required a standardized, objective number that separate banks could agree on led the industry to develop LIBOR as that standard reference.
LIBOR is calculated by surveying major banks in London each day and asking, "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?" The most extreme values are disregarded, and the remaining rates averaged to arrive at the official LIBOR rate. Thompson Reuters currently manages the survey and publication of LIBOR on behalf of the British Banker's Association.
Similar indexes have been created in other financial centers, such as EURIBOR (Europe-wide), HIBOR (Hong Kong), SIBOR (Signapore), TIBOR (Tokyo), and others. Each center tends to be most associated with a particular currency, but because of the depth of the U.S. dollar market and for historical reasons, LIBOR has remained the standard.
LIBOR as a Risk Indicator
The spread between U.S. dollar LIBOR rates and interest rates on U.S. Treasury securities of similar maturity is often taken as an indicator of the stability of the financial or credit systems, because it can be seen as an estimate of the credit-worthiness of the banking sector. Market participants often call this the TED-spread, or the spread between U.S. Treasury (E-) rates and EuroDollar (-ED) contracts that use LIBOR. Since bank borrowing costs carry over into the borrowing costs of nearly every other borrower, the entire economy is sensitive to these rates.
In normal times, when banks are stable, the spread between dollar LIBOR and Fed Funds is only about 0.25%-0.50%, because major banks look very able to repay short-term borrowings. In times of crisis, however, this spread can widen tremendously. In the financial crisis of 2008, the spread rose to over 4.5% at the peak. The credit crunch a year earlier kicked the spread from 0.25% to nearly 2.5%. In retrospect, the credit crunch was the first substantial shock of the recent crisis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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