London Interbank Offered Rate

The LIBOR is a benchmark interest rate, often used to calculate mortgage loan rates and interest rate adjustments on variable rate loans.

What is the London Interbank Offered Rate (LIBOR)?

The London Interbank Offered Rate, or LIBOR for short, is a benchmark interest rate that's widely used across the financial industry to determine interest rates for various financial products. It's calculated based on the average interest rate that major banks in London charge one another for short-term loans in the interbank market.

Many financial products, including mortgages, student loans, and credit cards, use LIBOR as a benchmark rate to determine variable interest rates. This means that as LIBOR changes, so do the interest rates on these loans.

However, in recent years, concerns about potential manipulation of LIBOR by banks led to a decision to phase it out. 

How is London Interbank Offered Rate calculated?

So, the London Interbank Offered Rate, or LIBOR, is calculated by taking an average of the interest rates that a panel of major banks in London report they would be charged for short-term loans from other banks. 

For example, if you're calculating the LIBOR for a 6-month loan period, the panel of banks will submit their estimates for what they would charge to lend money to another bank for that period.

Once all the estimates are in, the highest and lowest estimates are thrown out to prevent any outliers from affecting the average. Then, the remaining estimates are averaged together to determine the LIBOR rate for that day.

Let's say there are 10 banks on the panel, and they report the following estimates for a 6-month loan period:

Bank A: 1.5%, Bank B: 1.6%, Bank C: 1.7%, Bank D: 1.8%, Bank E: 1.9% ,Bank F: 2.0%, Bank G: 2.1%, Bank H: 2.2% ,Bank I: 2.3%, Bank J: 2.4%

The highest and lowest estimates (Bank J at 2.4% and Bank A at 1.5%) would be thrown out, and the remaining eight estimates would be averaged together to determine the LIBOR rate for that day. So in this example, the LIBOR rate would be 1.9%.

What is LIBOR Used For?

LIBOR, is used as a benchmark interest rate that's often referenced in financial contracts, including mortgages, student loans, and credit cards. Essentially, LIBOR serves as a standard reference point for determining the interest rate that borrowers will be charged for various types of loans.

For example, if you have a variable rate mortgage, your interest rate may be tied to LIBOR. This means that when LIBOR goes up, your mortgage rate goes up as well, and when LIBOR goes down, your mortgage rate goes down.

LIBOR is also used in financial derivatives, which are financial contracts that are based on the value of an underlying asset. For instance, a company might use a derivative contract to hedge against changes in the value of a commodity like oil or gold. In this case, the value of the derivative might be tied to LIBOR, which would be used as a reference point for determining the interest rate that the company would pay or receive under the contract.

It plays a crucial role in global finance and is a key reference point for determining interest rates in a wide variety of financial contracts.

Why is LIBOR Being Phased Out?

LIBOR is being phased out because of concerns about its reliability and potential manipulation. In the past, there have been instances of banks manipulating LIBOR to their advantage, which has led to investigations and fines.

Additionally, the underlying market that LIBOR is based on has become less active, making it difficult to maintain an accurate benchmark rate. This lack of activity is due in part to regulatory changes following the financial crisis, which have made it more expensive for banks to borrow from each other.

To address these concerns, regulators in the UK and US have decided to phase out LIBOR and replace it with alternative benchmark rates that are more reliable and better reflect the underlying market. 

What May Replace LIBOR?

Following are some potential replacements for LIBOR:

• Secured Overnight Financing Rate (SOFR): This is a benchmark rate based on transactions in the U.S. Treasury repurchase market. It's considered a more reliable benchmark than LIBOR because it's based on actual transactions rather than bank estimates.
• Sterling Overnight Index Average (SONIA): This is a benchmark rate based on overnight unsecured transactions in the sterling market. It's already being used in the UK as a replacement for LIBOR in some markets.
• Tokyo Overnight Average Rate (TONA): This is a benchmark rate based on unsecured overnight call market transactions in Tokyo. It's being developed as a replacement for LIBOR in Japan.
• Euro Short-Term Rate (ESTER): This is a benchmark rate based on overnight unsecured transactions in the eurozone. It's being developed as a replacement for LIBOR in Europe.

In addition to the above, there are a number of other benchmark rates being developed for specific regions or currencies. These include the Hong Kong Interbank Offered Rate (HIBOR), the Singapore Overnight Rate Average (SORA), and the Swiss Average Rate Overnight (SARON).

Conclusion

LIBOR has been a widely used benchmark interest rate for many years, but its reputation has been tarnished due to concerns about its reliability. As a result, financial regulators have decided to phase it out and are working on developing new benchmark rates to replace it. 

While it may take some time for these new rates to become fully established, they are expected to be more transparent, reliable, and less vulnerable to manipulation. It will be interesting to see which of the new benchmark rates ultimately becomes the most widely used and trusted, but for now, it's crucial for borrowers and lenders to keep an eye on developments in this area and be prepared for any changes that may affect their loans or investments.