LIBOR Essay ⋆ Business Essay Examples ⋆ EssayEmpire

LIBOR, or London Interbank Offered Rate, is the interest rate at which banks in London will lend large denomination Eurocurrency deposits to other banks for specific maturities. LIBOR is the ask price in a bid/ask spread interest rate quotation. The bid price is LIBID, or London Interbank Bid Rate. LIBOR can refer to any interbank lending rate offered on short-term Eurocurrency deposits but generally the term refers to the reference rate established by the British Bankers’ Association (BBA).

Since January 1986 the BBA has set a daily reference LIBOR or BBA LIBOR. Each London business day, interbank offered rates from eight to 16 reference banks, as determined by the BBA, are assembled for 10 major currencies. To calculate BBA LIBOR, the middle two quartiles of the compiled quotations lending rates for a specific currency and maturity are averaged. The averaged rates are then distributed each morning to market participants through such business news services as Reuters and Bloomberg.

For the various maturities LIBOR is quoted on the basis of a 360-day year except for quotations for British pounds, which use an actual 365-day year. Currently the BBA distributes 150 daily rates each day reflecting 15 maturities that range from overnight to one year in the 10 currencies. BBA LIBOR serves as a benchmark or base rate for the pricing of an estimated $350 trillion in loans, derivatives, and other financial products around the world, including interest rate swaps, floating rate notes, syndicated loans, and adjustable rate mortgages.

Origins And Development

As a rate on Eurocurrency or offshore deposits, LIBOR originated with the Eurodollar market in the post–World War II era. Avoidance of U.S. government regulation that then prohibited the payment of interest on short-term dollar deposits and placed ceilings on interest paid on longer-term deposits is credited with spurring the development of the Eurodollar market. Subsequent restrictions on capital outflow from the United States in the 1960s led to its further growth.

The oil shocks in the 1970s and the resulting increase in offshore dollars are also cited as important contributors to the emergence of the Eurodollar market. Because the interbank market for Eurodollars became centered in London, the world’s leading financial center second only to New York, the term LIBOR arose for quotations in this market. Subsequently similar terms have arisen for interbank offered rates in other international financial centers, such as SIBOR in Singapore and BIBOR in Bahrain.

One explanation for the growth of the Eurocurrency market is greater efficiency in that market because of less regulation and lower deposit intermediation costs as well as significant economies of scale in operations. As a result, LIBOR is a competitive funding rate or cost of funds for banks. Arbitrage, profit-seeking through the simultaneous buying and selling of (near) equivalent financial instruments to exploit price discrepancies across markets, ensures that LIBOR on U.S. dollars tracks such close equivalents as the overnight U.S. federal funds rate and U.S. certificates of deposit. However, these rates are not complete equivalents. Lower LIBOR costs due to greater operational efficiency in the Eurocurrency markets may be offset by the risks inherent in an unregulated banking market without a lender of last resort or deposit insurance.

The Treasury-Eurodollar Spread

U.S. dollar LIBOR has also been found to have a long-term equilibrium relationship with rates on U.S. Treasury bills (T-bills) for equivalent maturities with LIBOR exceeding T-bill rates by a relatively stable spread due to the existence of greater risk on LIBOR borrowings. This difference between LIBOR and T-bill rates, specifically 90-day rates, is a financial market indicator known as the TED (Treasury-Eurodollar) spread that is used to measure financial market liquidity and credit risk. Historically the TED spread tends to average below 0.5 percent or 50 basis points, with greater spreads seen as indicators of a lessening of confidence in banks and the financial system.

In 2007–08 during the subprime financial crisis, the accuracy of BBA LIBOR as a benchmark rate was called into question. There were reports that reference banks had been understating their LIBOR rates in order to appear more liquid than they were in reality. The BBA agreed to investigate and subsequently announced measures to better ensure the reliability of BBA LIBOR.

Bibliography:

British Bankers’ Association, “BBA Announces Steps to Strengthen LIBOR” (2008);
British Bankers’ Association, “City Speak: Taking the Mystery Out of Money” (2008);
M. Clinebell et al., “Integration of LIBOR and Treasury Bill Yields Over Different Monetary Regimes,” Global Finance Journal (2000): M. Goodfriend, “Eurodollars,” in Instruments of the Money Market, T. Cook and R. Laroche, eds. (Federal Reserve Bank of Richmond, 1993);
Mark Joshi and Alan Stacey, “New and Robust Drift Approximations for the LIBOR Market Model,” Quantitative Finance (v.8/4, 2008);
Fabio Mercurio, LIBOR Market Models and Smile: Latest Extensions and Their Applications (John Wiley, 2007);
Mollenkamp, “LIBOR Fog: Bankers Cast Doubt on Key Rate Amid Crisis,” Wall Street Journal (2008);
Oppenheim, International Banking, 6th ed. (American Bankers Association, 1991);
Solnik and D. McLeavey, International Investments (Pearson AddisonWesley, 2003).

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