Definition
London Interbank Offered Rate (LIBOR)
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another for short-term loans in the international market. It serves as the leading reference rate for numerous financial instruments worldwide, including Eurodollar-based loans, derivatives, and mortgages. LIBOR is determined daily and varies by loan maturities ranging from overnight to one year.
Examples
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Short-term Corporate Loans: A multinational corporation might secure a short-term loan from an international bank with an interest rate tied to LIBOR plus a certain percentage. For example, a loan rate might be specified as “LIBOR + 2%.”
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Adjustable Rate Mortgages (ARMs): Some mortgage lenders use LIBOR as a reference rate for setting adjustable rate mortgages. For instance, the interest rate of an ARM might reset annually based on the current LIBOR rate plus a margin.
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Derivatives Trading: Traders use LIBOR as a benchmark rate in various financial derivatives contracts, such as interest rate swaps and futures. For example, two parties might enter into a swap agreement to exchange fixed interest payments for floating payments based on LIBOR.
Frequently Asked Questions (FAQ)
1. What is LIBOR used for?
LIBOR is used as a global benchmark interest rate for financial products such as loans, mortgages, and derivatives. It serves both as a reference rate for financial instruments and a gauge of liquidity in the international banking system.
2. How is LIBOR calculated?
LIBOR is calculated based on submissions from a panel of major global banks, which report the rates at which they can borrow unsecured funds from other banks. The submitted rates are averaged after trimming outliers to arrive at the final LIBOR value for different maturities.
3. Why is LIBOR important?
LIBOR is significant because it influences the costs of borrowing and lending globally. It serves as a reliable indicator of prevailing interest rates in the interbank lending market, affecting trillions of dollars in financial products.
4. Is LIBOR being replaced?
Yes, LIBOR is being phased out and replaced by alternative reference rates like the Secured Overnight Financing Rate (SOFR) due to concerns about its reliability and manipulation. Financial markets are transitioning to these new benchmarks to ensure more secure and transparent lending standards.
5. What are Eurodollars?
Eurodollars are US dollars deposited in banks outside the United States, primarily used in international trade and financial transactions. They form the basis for transactions that reference LIBOR.
Related Terms
Federal Funds Rate
The interest rate at which domestic U.S. banks lend funds to each other overnight. It serves as a benchmark for all types of loans, similar to LIBOR for Eurodollars.
Secured Overnight Financing Rate (SOFR)
A benchmark interest rate for U.S. dollar-denominated derivatives and loans that is replacing LIBOR. It is based on transactions in the U.S. Treasury repurchase market.
Eurodollars
U.S. dollars deposited in banks outside the United States. They are typically used in international markets as part of lending and deposit schemes.
Online References
Suggested Books for Further Studies
- “Interest Rate Markets: A Practical Approach to Fixed Income” by Siddhartha Jha
- “Financial Markets and Institutions” by Frederic S. Mishkin and Stanley G. Eakins
- “Handbook of Financial Risk Management” by Thierry Roncalli
Fundamentals of LIBOR: Finance Basics Quiz
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