The London interbank offered rate (LIBOR) represents the average of the interest rates charged by the leading banks in London. The LIBOR is considered to be an important interest rate in finance. The LIBOR is the most widely used benchmark for short term interest rate. The primary function is to serve as a reference point for debt instruments such as government bonds, corporate bonds, mortgages, loans, credit cards etc. The LIBOR is the average interest rate that banks can borrow from each other. The LIBOR rate is not just for the banks in London. It is called the London interbank offered rate because the benchmark is set in London. The calculations are performed by Thomas Reuters.
How is the rate calculated?
The LIBOR is based on 5 currencies namely: US dollars (USD), EURO (EUR), Sterling (GBP), Japanese Yen (YPN), and Swiss Franc (CHF). Also, there are 7 different maturities: the overnight, one week, and 1,2,3,6 and 12 months making a total of 35 different LIBOR rate each business day. A selection of panel banks for top banks such as: CITI group, JP Morgan Chase, Bank of America, Barclays, UBS and others estimate the amount of interest they are willing to borrow another bank in the short term. The process is overseen by the ICE benchmark Administration (IBA) and calculated by Thomas Reuters.
Why is LIBOR so important?
Benchmark: As mentioned, the LIBOR is very important as it sets the base rate for short-term interest rates
Economic evaluation: the LIBOR rate helps to evaluate the current state of the worlds banking system. The financial institutions are very important when considering the health of the economy. So that’s why investors keep a close eye on the LIBOR rates.
Central bank interest rate: professional analyst monitor the LIBOR rate as it guides them or sets an expectation for future central bank interest rate changes.
The LIBOR Scandal
The scandal was made known in 2008 during the financial crisis. Financial institutions have been accused of fixing the LIBOR. Being an important indicator of the interest rate and used by so many institutions, bankers from various financial institutions that provide the interest rate were accused of understating the interest rate to artificially keep the LIBOR rate low. The effect on the economy at the time was that, since it’s an indicator of the health of the banks, during the 2007-2008 financial crisis, some banks appeared stronger than they actually were.
As an investor it’s important to constantly look at the graphs plotted on the LIBOR rates as this can give you a sense of how and when to invest over a period of time. Investment banks use it and its available to individuals as well. Happy investing!!!!