London Interbank Offer Rate (LIBOR) – Definition

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London Interbank Offer Rate (LIBOR) Definition

LIBOR is the acronym or short form of London Interbank Offer Rate. This refers to the international reference rate for unsecured borrowing over a short period in the interbank market. It serves as a standard for interest rates that are short-termed. It is used to price currency rate swaps, interest rate swaps, and mortgages. It functions to check how the financial system is faring health-wise and also gives an idea of the trajectory of the imminent central bank policy rates.

A Little More on What is LIBOR

When talking about the syndicated loan market, pricing of credits is at LIBOR + rates. The rate is determined by the borrower’s risk in the sense that the high the borrower’s risk, the higher the rate. For example, a lower risk AAA borrower might pay LIBOR + 50 basis points while a high-risk BBB borrower would pay LIBOR + 250 basis points. The Intercontinental Exchange (ICE) administers the London Interbank Offer Rate (LIBOR) and it’s computed for 5 different currencies, having 7 various maturity level spanning from overnight to one year. The five currencies for which it is computed include the euro, Swiss franc, Japanese yen, pound sterling, and the U.S. dollar. The Intercontinental Exchange benchmark administration comprises between 11 and 18 banks which contribute to each currency. The London interbank bid rate (Libid) is quoted by the bank intending to borrow funds or take deposits from a different bank while the London interbank mean rate (Limean) refers to the average of both of them.

Apart from helping in the decision of other transactions, it is also utilized as a trust measure in the financial system. Furthermore, it shows how confident banks are in the financial health of one another. This is the reason for its importance.

There is a system that is followed by banks when lending money. This implies that they do not lend money to each other anytime they please. Each day, a set of leading banks submit the interest rate at which they would lend other finance houses. They recommend rates in ten currencies covering fifteen various loan periods, spanning from overnight to twelve months. The 3-month dollar LIBOR is the most important rate. Whatever rates submitted are exactly what the banks know they will pay other banks when borrowing dollars for 3 months provided they borrowed money on the exact day the rate was set. After this, an average is calculated. This is an easy illustration of how it works.

A major review of Libor, as well as, its setting were commissioned by the government after the allegations became known. Libor oversight was passed from the British Banker’s Association to the Intercontinental Exchange (ICE). At the moment, rates are based on real transactions for which records are kept. Another major change is the fact that certain criminal penalties now exist for manipulating benchmark interest rates.

References for LIBOR

Academic Research on London Interbank Offer Rate (LIBOR)

•    The effect of the term auction facility on the London interbank offered rate, McAndrews, J., Sarkar, A., & Wang, Z. (2017). Journal of Banking & Finance, 83, 135-152. This article is based on how the term auction facility affects the rate offered by London interbank. Term Auction Facility (TAF) refers to the first liquidity initiative that was based on auction by the Federal Reserve. It became existent during the global financial crisis and it was established to improve the dollar money market conditions. It was also aimed at improving the dollar money market conditions, as well as, reducing the highly elevated London interbank offered rate (Libor). This creative policy tool’s effectiveness is needed to understand central bank’s role in financial stability. But academic researches disagree on the empirical observation of the Term Auction Facility impact in Libor. This disagreement is as a result of the wrong specification of econometric models.

•    Interbank rate fixings during the recent turmoil, Gyntelberg, J., & Wooldridge, P. (2008). This article explicates the recent turmoil and how it affected the interbank rate fixings. In the second half of 2007, the turmoil which occurred in global interbank markets resulted in questions about the robust nature of interbank rate fixings. Alternative fixings for alike interest rates were compared which confirmed that they varied to an unusual level. Nonetheless, the design of fixing mechanisms worked as planned to moderate the changing credit quality perceptions, as well as, the effect of strategic behavior.

•    Tracking the Libor rate, Abrantes-Metz, R. M., Villas-Boas, S. B., & Judge, G. (2011). Applied Economics Letters, 18(10), 893-899. This paper is based on monitoring the London interbank offered rate. The period tracked is between 2005 and 2008 using Benford’s law. This law is present in some financial data sets, as well as, many numerical data sets that occur naturally. Based on the research, it is discovered that in two current periods, Libor rates have significant variance from the anticipated Benford reference distribution. This results in major concerns relative to the impartial nature of the signals that come from the 16 banks from which the London interbank offered rate is computed.

•    The term structure of interest rates in the London interbank market, Hurn, A. S., Moody, T., & Muscatelli, V. A. (1995). Oxford Economic Papers, 47(3), 418-436. This research work focuses on the London interbank market and its term structure of interest rates. The hypothesis is tested that the longer-term rates which are determined by expectations of future short-term rates are as a result of the highly competitive nature of the London interbank market. The co-integration tests, as well as, the VAR approach are employed. The results generally support the expectations hypothesis and contrary to previous studies that have used the VAR approach, the restrictions suggested by the expectations hypothesis cannot be rejected. It’s only at the end of the interbank spectrum that a sign of marginal deviations from the expectations hypothesis may surface.

•    Long-range dependence and multifractality in the term structure of LIBOR interest rates, Cajueiro, D. O., & Tabak, B. M. (2007). Physica A: Statistical Mechanics and its Applications, 373, 603-614. This paper focuses on the LIBOR interest rate’s term structure and its long-range dependence and multi-fractal nature. A data set is studies for this research from 2000 to 2005. This is done for six currencies, as well as, various maturities. The results suggest that the level of long-range dependence reduces with maturity, except for interest rates on Indonesian Rupiah and on Japanese Yen. Also, interest rates are multifractal in nature and the multifractality level is much stronger for Indonesia, being an emerging market. Based on the findings, it is discovered that these features should be considered by interest rate derivatives.

•    The term structure of interbank risk, Filipović, D., & Trolle, A. B. (2013). Journal of Financial Economics, 109(3), 707-733. This paper is based on interbank risk and its term structure. A term structure of interbank risk was inferred from spreads between London Interbank Offered Rate (LIBOR) indexed swaps, as well as, the overnight indexed swaps. A tractable model of interbank risk is developed in order to breakdown the term structure into both default and also non-default components. The fraction of summary of interbank risk as a result of default risk between August 2007 and January 2011 increased with maturity. When talking about short maturities, the importance of the non-default component is in the first part of the sample period and it correlates with funding measures, as well as, market liquidity. Furthermore, the model provides a framework for risk management, pricing and also hedging of interest rate swaps with the significant risk being present.

•    Mean reversion and volatility of short-term London interbank offer rates: An empirical comparison of competing models, Adkins, L. C., & Krehbiel, T. (1999). International review of economics & finance, 8(1), 45-54. This article attempts to compare competing models. It pays attention to the short-term London interbank offer rates with reference to its mean reversion and how volatile it is. The stochastic process stated for certain interest rates determines the pricing of many long-dated and short-dated derivatives. In this work, the authors examine the properties of various stochastic processes set to the time sequence of the three-month and six-month London Interbank Offer Rates. For the three-month series, the sample period was between January 1984 and June 1995 while the sample period for the six-month series was between June 1988 and February 1996. In testing the parameter descriptions, the authors used the Euler-Maruyama discrete-time approximation to test and estimate parameter restrictions. The test revealed that none of the three-month or six-month LIBOR is mean reverting.

•    LIBOR: origins, economics, crisis, scandal, and reform, Hou, D., & Skeie, D. R. (2014). This paper explicates the origins, crisis, reform, economics, and scandal of London Interbank Offered Rate. LIBOR is widely used to indicate funding conditions in the interbank market. By 2013, LIBOR underpinned over $300 trillion worth of financial contracts with the inclusion of futures and swaps, in addition to more trillions in student loans and variable-rate mortgage. LIBOR’s volatility during the financial crisis roused questions surrounding its authenticity. Ongoing regulatory findings have revealed misconduct by several institutions. Policymakers around the world now battle with reforming LIBOR after the crisis and scandal.

•    Does the LIBOR reflect banks’ borrowing costs?, Snider, C. A., & Youle, T. (2010). This article intends answering the question about LIBOR reflecting the borrowing costs of banks. LIBOR is a major standard interest rate to which financial contracts worth hundreds of trillions of dollars are tied. Of recent, observers have been concerned about LIBOR not accurately reflecting the average bank borrowing costs, its evident target. Based on observable cost measures, it is shown that in the Libor survey, bank quotes are difficult to rationalize. The second evidence is based on an easy model of bank quote choices meant to predict that if banks have the incentive to affect rates, the bunching of quotes should be seen around certain points and there would be no such bunching where these incentives are absent.

•    Reforming LIBOR and other financial market benchmarks, Duffie, D., & Stein, J. C. (2015). Journal of Economic Perspectives, 29(2), 191-212. This article is based on reforming LIBOR, as well as, other financial market benchmarks. Here, major steps needed to reform LIBOR are outlined in order to enhance its robustness to manipulation. Certain things are discussed. First, the role of financial benchmarks in encouraging over-the-counter market effectiveness by improving transparency is discussed. Next, the process involved in mitigating LIBOR manipulation incentives is discussed. One way is by widening the transaction types used in fixing LIBOR.

•    A Yen is Not a Yen: TIBOR/LIBOR and the Determinants of the Japan Premium, Covrig, V., Low, B. S., & Melvin, M. (2004). Journal of Financial and Quantitative Analysis, 39(1), 193-208. Either LIBOR, set at 11 am London time or TIBOR, set at 11 am Tokyo time determines pricing in the Euro-Yen market. LIBOR refers to the London Interbank Offer Rate while TIBOR refers to the Tokyo Interbank Offer Rate. Since non-Japanese banks are dominating the LIBOR panel and the Tokyo city banks are dominating the TIBOR panel, the changing TIBOR-LIBOR spread indicates the credit risk related to Japan premium or Japanese banks. The determinants of Japan premium are investigated in this paper. Based on the results, it is discovered that interest rate, as well as, stock price effects combined with public information of good and bad news concerning Japanese banking can explain the systematic variation of the spread.

•    The effect of underreporting on LIBOR rates, Monticini, A., & Thornton, D. L. (2013). Journal of Macroeconomics, 37, 345-348. This article examines how LIBOR rates are affected by underreporting. On the 29th of May, 2008, it was reported by the Wall Street Journal that a number of big international banks were reporting inexcusable LIBOR rates that were low. Since the report, two large banks known as UBS and Barclays have paid huge fines for altering their LIBOR rates and other banks are meant to be fined as well. This article analyzes the underreporting of LIBOR rates by certain banks and if it had a major effect on the reported LIBOR rates. This was tested by if there was a major change in the relations holding between the LIBOR rate and a different rate which shows banks’ default risk.

 

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