LIBOR Essay

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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: 

  1. British Bankers’ Association, “BBA Announces Steps  to  Strengthen   LIBOR” (2008);
  2. British Bankers’ Association, “City  Speak:  Taking  the  Mystery Out of Money” (2008);
  3. 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);
  4. Mark Joshi and Alan Stacey, “New and Robust Drift Approximations for the LIBOR Market Model,” Quantitative Finance (v.8/4, 2008);
  5. Fabio Mercurio, LIBOR Market Models and Smile: Latest Extensions and  Their Applications  (John Wiley, 2007);
  6. Mollenkamp,  “LIBOR Fog: Bankers Cast Doubt on Key Rate Amid Crisis,” Wall Street Journal (2008);
  7. Oppenheim, International  Banking, 6th ed. (American  Bankers Association, 1991);
  8. Solnik and D. McLeavey, International Investments (Pearson AddisonWesley, 2003).

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