Definition
London InterBank Offered Rate (LIBOR) is the rate of interest at which major global banks lend funds to each other in the international interbank market for short-term loans, ranging from overnight to a period of up to five years. LIBOR is recognized globally and is critical in setting various financial contracts and instruments.
Examples
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Corporate Loans: Many corporate loans have interest rates tied to LIBOR. For example, a corporation might take out a loan with a rate expressed as “LIBOR + 2%”. If the 3-month LIBOR is 0.5%, the interest rate on this loan would be 2.5%.
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Mortgages: Adjustable-rate mortgages (ARMs) in various countries often use LIBOR as a reference rate. The initial interest rate might be fixed for a certain period before adjusting annually based on the current LIBOR rate plus a fixed margin.
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Derivatives: LIBOR is commonly used in pricing derivatives such as interest rate swaps. In an interest rate swap, one party might pay a fixed rate while the other pays a rate based on LIBOR.
Frequently Asked Questions (FAQs)
What is LIBOR used for?
LIBOR serves as a global benchmark for setting the interest rates on loans, mortgages, and various financial instruments. It reflects the cost of borrowing funds in the market and hence is pivotal in the financial services industry.
How is LIBOR determined?
LIBOR is determined by averaging the interest rates submitted by a panel of leading banks on the rates they would charge for unsecured loans to other banks - all done daily across multiple maturities and currencies.
Why is LIBOR important?
LIBOR is critical because it influences the interest rates on various financial products, including mortgages, corporate loans, and derivatives. It reflects global monetary conditions and the health of banking sectors.
What was the LIBOR scandal?
In 2012, it was discovered that several banks manipulated the LIBOR rate to benefit their own trading positions. This scandal involved falsifying interest rate submissions to appear more creditworthy or to influence derivatives’ payoffs.
Who oversees LIBOR now?
Following the scandal, the responsibility for administering LIBOR was transferred from the British Bankers’ Association (BBA) to the Intercontinental Exchange (ICE), specifically through its subsidiary, ICE Benchmark Administration (IBA).
Related Terms
- London InterBank Bid Rate (LIBID): The rate at which banks are willing to borrow from each other in the interbank market.
- Euribor: The Euro Interbank Offered Rate, a similar benchmark for interest rates within the Eurozone.
- Fed Funds Rate: The interest rate at which depository institutions lend funds maintained at the Federal Reserve to each other, primarily within the United States.
Online References
Suggested Books for Further Studies
- “The LIBOR Scandal: The Fixing of Interest Rates” by Jack Lee
- “Swaps and Other Derivatives” by Richard R. Flavell
- “Interest Rate Markets: A Practical Approach to Fixed Income” by Siddhartha Jha
Accounting Basics: “LIBOR” Fundamentals Quiz
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