LIBOR is the acronym given to London Interbank Offered Rate.
It is a global reference acting as a benchmark for interest rates for unsecured
short-term loans between banks. It is computed for five currencies (Swiss
Franc, Pound Sterling, Japanese Yen, US Dollar and Euro). Although it was set
up by the British Bankers Association (BBA) after the financial crisis of 2008 a
need to change the administering party was felt and as a result the
Intercontinental Exchange (ICE) became operational in its LIBOR administrations
from February 2014 and now takes care of LIBOR. The loans are given under seven
different maturity periods (overnight, 1 week, 1 month, 2 months, 3 months, 6
months, 12 months).
The method for calculating LIBOR includes participation of 11 to 18 banks contributing to each currency and thus follows a consensus mechanism followed by a trimmed mean approach. The banks give their individual rates of interest at which they are willing to borrow or lend loans to other banks, which are then arranged in descending order and divided into four equal groups (quartiles). The top most and bottom most quartile comprising 3 or 4 values of interest rates are eliminated and a mean of the leftover values is taken to decide the rate. This process is repeated for each of the five currencies and the seven maturity rates thus giving a total of 35 reference rates. These rates are then used for the interbank loan systems for the specific currency and maturity pair they are chosen for.
As the value of LIBOR changes, the interest paid changes and
thus to avoid conflicts LIBOR is both fixed and floating at the same time.
Loans can be fixed at rates like (LIBOR + 2%) to have security of returns and
for the opportunity of variable income. LIBOR acts as an indicator of the
overall health of banking system and sometimes accounts for liquidity premiums
for instruments that are traded in the money markets. It also acts a standard
gauge of market expectation for interest rates as finalised by central banks.
LIBOR is used globally for the exchange of various financial
products which include the following:
- Forward Rate Agreements (FRA)
- Interest Rate Swaps
- Interest Rate Options/Futures
- Syndicate Loans
- Variable Rate Mortgages
- Floating Rate Certificate of Deposits and Notes
- Collateralised Debt Obligations (CDO)
- Collateralised Mortgage Obligations (CMO)
- Individual Mortgages
- Student Loans
Though LIBOR is accepted globally, there are other such
offered interest rates that are used regionally as well as across the globe.
Some of these include Tokyo Interbank Offered Rate (TIBOR), European Interbank
Offered Rate (EUROBOR), Shanghai Interbank Offered Rate (SHIBOR), Mumbai Interbank
Offered Rate (MIBOR).