Thursday, May 27, 2010

What is LIBOR?

What is LIBOR?

LIBOR stands for the London Inter Bank Offer Rate and is a measure of the average rate of interest at which banks can borrow money unsecured from each other in various currencies for various periods.

LIBOR is used to price a lot of financial contracts, for example a company might borrow money from a bank at LIBOR + 0.75% and according to the British Bankers Association, USD10,000,000,000,000 of loans are linked to LIBOR! Changes in LIBOR can signal changes in the money markets, for example a rise in LIBOR might be triggered by the expectation that interest rates will rise or the fear that it has gotten riskier to lend money to banks in general. LIBOR is quoted at an annualized rate, for example overnight LIBOR at 3% = 3%/365 = 0.00822%.

To calculate LIBOR, between 8 and 16 banks are asked to input the answer to the following question into a Reuters terminal (a secure information and messaging service):

At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?

It is up to the banks concerned to interpret the question (for example ‘reasonable market size’ is undefined). This question is asked and answered for 10 different currencies* over 15 different lengths of loan** to create 150 different LIBORs.

The answers are collated, the highest and lowest 25% of interest rates reported are discarded and the middle 50% taken and an arithmetic mean calculated.

*Pound Sterling, US Dollar, Japanese Yen, Swiss Franc, Canadian Dollar, Aussie Dollar, Euro, Danish Kroner, Swedish Krona and New Zealand Dollar

**1 day (aka overnight or spot/next), 1 week, 2 weeks, 1 month, 2 months, 3 months…..12 months.

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