Introduction to LIBOR

When most Americans think of British imports, they may think of James Bond and Monty Python movies in their minds. These are all good contributions. With the success of the above-mentioned British imports, it is difficult to demonstrate their importance, but it is likely that the most important imports from the United Kingdom have had a direct impact on many Americans, especially homeowners’ wallets. Influence. In this article, we will explain a little-known but extremely relevant financial instrument used worldwide-the London Interbank Offered Rate (LIBOR)

Key points

  • The London Interbank Offered Rate (LIBOR) is similar to the federal funds rate. It is an interest rate that major banks around the world lend to each other in the international interbank market for short-term loans.
  • In recent years, regulatory reforms have begun to reform the benchmark interest rate and eventually replace LIBOR as the inter-bank lending rate.
  • LIBOR will be phased out. The alternative recommended by the United States is the Guaranteed Overnight Financing Rate (SOFR), which will replace LIBOR in 2023.

What is the London Interbank Offered Rate?

LIBOR is equivalent to the federal funds rate, or the loan interest rate charged by one bank to another bank. The emergence of LIBOR can be traced back to 1984, when the British Bankers Association (BBA) tried to add appropriate trading terms to actively traded markets, such as foreign currencies, forward interest rate agreements, and interest rate swaps.

LIBOR was used in the financial market for the first time in 1986 after trial operation in the first two years. LIBOR has reached such a high level that the BBA publishes the interest rate every day.

The scope of LIBOR’s influence can be felt thousands of miles from the Thames; it is used as a key reference point for financial instruments such as futures contracts, U.S. dollars, interest rate swaps, and floating rate mortgages.

LIBOR scope

LIBOR is set by 16 international member banks, and it is estimated that it sets interest rates for 360 trillion U.S. dollars in financial products around the world. These products include Adjustable Rate Mortgage Loans (ARM).

During periods of stable interest rates, LIBOR ARM may be an attractive option for home buyers. These mortgages have no negative amortization and in many cases provide a fair prepayment interest rate. A typical ARM index is linked to the six-month LIBOR interest rate plus 2% or 3% of the spread representing the risk premium.

The scope of LIBOR’s influence is not limited to homeowners. This interest rate is also used to calculate interest rates for small business loans, student loans, and credit cards. Normally, homeowners or others who need loans will not directly feel the heavy pressure of LIBOR. When the interest rate environment in the United States is stable and the economy is booming, LIBOR usually goes well.

Unfortunately, this coin has another side. During periods of economic uncertainty, especially in developed countries, LIBOR interest rates show signs of excessive volatility, making it more difficult for banks to issue and receive loans. This question will be passed on to those seeking bank loans. If the local bank’s cash is scarce or at a premium, the bank will only charge the borrower a higher interest rate, or worse, will not borrow money from you at all.

If time is not good, watch LIBOR

Another outstanding feature of LIBOR is that it can dilute the impact of the Fed’s rate cut. Most investors think the Fed’s rate cut is good, or at least they welcome the news. If the LIBOR rate is high, the Fed’s rate cut looks a lot like a vacation in Hawaii and it rains every day. The high LIBOR interest rate limits people’s access to loans, making the lower Fed discount rate irrelevant to ordinary people. If you have a subprime mortgage, you need to pay close attention to the LIBOR interest rate, because nearly $1 trillion in subprime mortgages is linked to LIBOR.

Although the LIBOR actions related to the foreign exchange market involve more currencies, such as the euro, pound sterling, yen, etc., its daily impact on the value of dollars spent in the United States is negligible, although it is worth noting that LIBOR and the euro or The interest rate on U.S. dollars held by foreign banks is very relevant. The euro accounts for about 20% of the total reserves of the dollar.

LIBOR replacement

Although LIBOR has been used since the 1980s, regulatory reforms have begun in recent years to reform the benchmark interest rate and eventually replace LIBOR as the inter-bank lending rate. It is expected that UK regulators will no longer require banks to announce LIBOR interest rates after 2021.

The alternative recommended by the United States is the Guaranteed Overnight Financing Rate (SOFR), which will replace LIBOR in 2023. SOFR is also the benchmark interest rate for U.S. dollar-denominated loans and derivatives. LIBOR is an estimate of the borrowing interest rate, while SOFR is based on actual observed transactions in the U.S. Treasury bond market, while LIBOR uses an estimate of the borrowing interest rate.

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