What is LIBOR?
LIBOR is an acronym for London Interbank Offered Rate. It is basically an interest rate used on the federal level. It’s the interest rate that is charged between banks for loans. As far as interest rates it is the busiest in the world of finance. There are a number of banks which participate in the money market in London and they offer short term deposits to each other. LIBOR is what is used to determine the price of several other financial derivatives. These include items such as futures for interest rates, Eurodollars and swaps. This is very influential throughout the world of finance as it affects more than just the Pound Sterling. It is also important to other currencies like the US Dollar, Canadian Dollar, Japanese Yen and the Swiss Franc.
Every morning in London at 11:00 am LIBOR is set. The exact rate is found by averaging the various interest rates which are being offered by the banks in membership with the British Bankers Association. It is calculated for different time frames from as short as a day to a full year. The banks may offer varying rates throughout each day but the rate set is fixed for a 24 hour time frame. Even when the instantaneous rate and LIBOR are different it is a very small increment and for a short time.
Eurodollar futures are the most important of the derivatives which are related to LIBOR. Eurodollars are basically US monies which are deposited in banks which are outside the United States, generally in Europe. These Eurodollars are traded in Chicago at the Chicago Mercantile Exchange. Depositors outside the country are not subjected to the margin requirements enforced by the Federal Reserve which gives the depositor more leverage over the funds. LIBOR determines the interest rate which is paid on these Eurodollars and these futures provide ways to bet or hedge against the changes in the future interest rate.
There are 16 member banks in the British Bankers Association and they control the rates on about $360 trillion worth in the financial markets and products around the world. This includes the adjustable rate mortgages (ARM), which is where it affects the average Joe. When the interest rates are stable it provides several decent options for those wishing to purchase homes. For these mortgages it means no negative amortization and usually there are fair rates in terms of repayment. Usually the ARM is guided by the 6 month LIBOR plus somewhere between 2 and 3 percent.
LIBOR’s influence affects more than just the homeowner it also affects the entrepreneur and loans for small businesses, students and credit cards. It is all good while the economic climate is stable and LIBOR is doing well. But when economic uncertainty looms, particularly in the developed countries then the rates become volatile. This makes it more difficult for the banks to exchange loans among themselves. This in turn makes it more difficult for others to obtain bank loans. The trouble is that when the system is volatile the bank simply raises its interest rates for the borrower, or offers fewer loans.
LIBOR can also affect Federal rate cuts. Usually investors such as Effi Enterprises enjoy it when the Federal government cuts rates. But when LIBOR rates soar it restricts people from obtaining loans. This means that the average person does not benefit from the discounted rate because fewer loans are being offered. For those with a subprime mortgage it is important to keep an eye on LIBOR rates.
Generally the LIBOR rates do not affect the US Dollar or have little effect. It mostly has an impact on the Euro, Japanese Yen and the British Pound. However, for monies from the US which are being held in foreign banks, it is a relevant issue.