Understanding LIBOR

LIBOR

LIBOR, which stands for London Inter Bank Offered Rate, serves as a globally accepted key benchmark interest rate that indicates borrowing costs between banks. The rate is calculated and published each day by the Intercontinental Exchange (ICE).

The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short term loans.

*  LIBOR is the benchmark interest rate at which major global lend to one another.
*  LIBOR is administered by the Intercontinental Exchange which asks major global banks how much they would charge other banks for short-term loans.
*  The rate is calculated using the Waterfall Methodology, a standardized, transaction-based, data-driven, layered method.

How Is LIBOR Calculated?

The ICE Benchmark Administration (IBA) has constituted a designated panel of global banks for each currency and tenor pair. For example, 16 major banks, including Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS constitute the panel for US dollar LIBOR. Only those banks that have a significant role in the London market are considered eligible for membership on the ICE LIBOR panel, and the selection process is held annually.

As of April 2018, the IBA submitted a new proposal to strengthen the calculation methodology. It suggested using a standardized, transaction-based, data-driven, layered method called the Waterfall Methodology for determining LIBOR.

–  The first transaction-based level involves taking a volume-weighted average price (VWAP) of all eligible transactions a panel bank may have assigned a higher weighting for transactions booked closer to 11:00 a.m. London time.
–  The second transaction-derived level involved taking submissions based on transaction-derived data from a panel bank if it does not have a sufficient number of eligible transactions to make a Level 1 submission.
–  The third level—expert judgment—comes into play when a panel bank fails to make a Level 1 or a Level 2 submission. It submits the rate at which it could finance itself at 11:00 a.m. London time with reference to the unsecured, wholesale funding market.

The IBA calculates the LIBOR rate using a trimmed mean approach applied to all the responses received. Trimmed mean is a method of averaging which eliminates a small specified percentage of the largest and smallest values before calculating the mean. For LIBOR, figures in the highest and lowest quartile are thrown out and averaging is performed on the remaining numbers.

Uses of LIBOR

LIBOR is used worldwide in a wide variety of financial products. They include the following:

* Standard interbank products like the forward rate agreements (FRA), interest rate swaps, interest rate futures / options, and swaptions
* Commercial products like floating rate certificate of deposits and notes, syndicated loans, and variable rate mortgages
* Hybrid products like collateralized debt obligations (CDO), collateralized mortgage obligations (CMO), and a wide variety of accrual notes, callable notes, and perpetual notes
* Consumer loan-related products like individual mortgages and student loans

LIBOR is also used as a standard gauge of market expectation for interest rates finalized by central banks. It accounts for the liquidity premiums for various instruments traded in the money markets, as well as an indicator of the health of the overall banking system. A lot of derivative products are created, launched and traded in reference to LIBOR. It is also used as a reference rate for other standard processes like clearing, price discovery, and product valuation.

Equivalents

Though LIBOR is accepted globally, there are other similar regional interest rates that are popularly followed across the globe.

For instance, Europe has the European Interbank Offered Rate (EURIBOR), Japan has the Tokyo Interbank Offered Rate (TIBOR), China has Shanghai Interbank Offered Rate (SHIBOR), and India has the Mumbai Interbank Offered Rate (MIBOR).

Scandal of Rate Rigging

While it has been a long-established global benchmark standard for interest rate, it has had its fair share of controversies including a major scandal of rate rigging. Major banks allegedly colluded to manipulate the rates. They took traders’ requests into account and submitted artificially low LIBOR rates to keep them at their preferred levels. The intention behind the alleged malpractice was to bump up traders’ profits who were holding positions in LIBOR-based financial securities.

Following reporting by the Wall Street Journal in 2008, major global banks which were on the panels and contributed to the LIBOR determination process faced regulatory scrutiny. It involved investigations by the U.S. Department of Justice. Similar investigations were launched in other parts of the globe including in the U.K. and Europe. Major banks and financial institutes including Barclays, ICAP, Rabobank, Royal Bank of Scotland, UBS, and Deutsche Bank faced heavy fines. Punitive actions were also taken on their employees who were found to be involved in the malpractice.

Products and Transactions

The simplest example of a LIBOR-based transaction is a floating rate bond which pays an annual interest based on LIBOR, says at LIBOR + 0.5%. As the value of LIBOR changes, the interest payment will change.

LIBOR also applies to interest rate swaps—contractual agreements between two parties to exchange interest payments at a specified time. Assume John owns a $1 million investment that pays him a variable LIBOR-based interest rate equal to LIBOR + 1% each quarter. Since his earnings are subject to LIBOR values and are variable in nature, he wants to switch to fixed-rate interest payments. Then there is George, who has a similar $1 million investment which pays him a fixed interest of 1.5% per quarter. He wishes to get a variable earning, as it may occasionally give him higher payments.

Both John and George can enter into a swap agreement, exchanging their respective interest receipts. John will receive the fixed 1.5% interest over his $1 million investment from George which equals $15,000, while George receives LIBOR + 1% variable interest from John.

If LIBOR is 1%, then George will receive 2% or $20,000 from John. Since this figure is higher than what he owes to John, in net terms George will get $5,000 ($20,000 – $15,000) from Paul. By next quarter, if LIBOR comes down to 0.25%, George will be eligible to receive 1.25% or $12,500 from John. In net terms, Paul will get $2,500 ($15,000 – $John) from George

Such swaps essentially fulfill the requirement of both the transacting parties who wanted to change the type of interest receipts (fixed and floating).

 


 

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LIBOR