London Interbank Offered Rate (LIBOR)

What is LIBOR?

• LIBOR is a widely used global benchmark interest rate. It represents the average interest rate at which banks estimate they can borrow from each other in the London interbank market for specific time periods.
• LIBOR is important because it is used as a reference rate for settling trades in various financial instruments such as futures, options, swaps, and other Derivatives.

Calculation

• To calculate LIBOR, a group of banks submits their estimated borrowing rates to Thomson Reuters, a news and financial data company, every business day.
• The extreme rates are removed, and the remaining rates are averaged to determine the LIBOR rate, which aims to represent the median borrowing rate.
• Previously, LIBOR was calculated for five major currencies and seven different time periods, resulting in 35 rates published each day.
• However, the UK Financial Conduct Authority phased out most of these rates, and after 31st December, 2021, only U.S. dollar LIBOR rates were allowed to be published.

Significance

• Many lenders, borrowers, investors, and financial institutions rely on LIBOR to determine interest rates and pricing for these transactions.
• Not only is LIBOR used in financial markets, but it also serves as a benchmark rate for consumer lending products like mortgages, credit cards, and student loans.
• It helps determine the interest rates that individuals and businesses pay on these loans.

Uses of London Interbank Offered Rate

• LIBOR is utilized in a wide range of financial products all around the world.
• Standard interbank products such as Forward Rate Agreements (FRA), interest rate swaps, interest rate futures, options, and swaptions give buyers the right but not the obligation to buy a security or interest rate product.
• Floating rate certificates of deposit and notes, variable rate mortgages, and syndicated loans, which are loans given by a consortium of lenders, are examples of commercial products.
• Collateralized debt obligations (CDO), collateralized mortgage obligations (CMO), and a variety of accrual notes, callable notes, and perpetual notes are examples of hybrid products.
• Individual mortgages and student loans are examples of consumer loan products.
• LIBOR is also utilized as a standard indicator of market expectations for central bank interest rates.
• It is a measure of the liquidity premiums for various money market instruments as well as an indicator of the overall health of the banking system.
• LIBOR is used to construct, launch, and trade a variety of derivative instruments.
• Other conventional operations such as clearing, price discovery, and product valuation use LIBOR as a reference rate.

Conclusion

Loan contracts (ECBs or external commercial borrowings) connected to LIBOR, FCNR (B) deposits with floating rates of interest related to LIBOR, and derivatives linked to LIBOR or the MIBOR are all sources of LIBOR exposure in India. According to the RBI, around $50 billion in debt obligations in the form of ECB/FCCBs and $281 billion in derivative contracts will expire after 2021, based on preliminary estimates. These amounts, however, are not static, since new LIBOR-related contracts continue to be inked. There are other government exposures associated with LIBOR. The government's LIBOR-referenced loans from multilateral/bilateral organizations, as well as lines of credit given to foreign countries, are among them, according to the report.