Definition of London Interbank Offered Rate
What is the London Interbank Offered Rate
The London Interbank Offered Rate (LIBOR) has historically been a vital benchmark interest rate that represents the average rate at which major international banks lend to one another in the global interbank market for short-term loans. As a crucial component of the worldwide financial system, LIBOR plays a significant role in the currency and foreign exchange (forex) markets, influencing interest rates, debt instruments and other financial products.
How is LIBOR Calculated
LIBOR is calculated for five key currencies, including the US Dollar, Euro, British Pound Sterling, Japanese Yen and Swiss Franc, covering seven distinct maturities ranging from overnight to 12 months. This daily rate is determined by the Intercontinental Exchange (ICE), which gathers submissions from a panel of participating banks that provide their estimated interest rates for unsecured interbank lending across each currency and maturity. By excluding the highest and lowest quartiles of these submissions and averaging the remaining values, ICE calculates the final LIBOR rate for every currency and maturity.
Importance of LIBOR
As an essential reference rate in global finance, LIBOR serves as the basis for various financial transactions, such as corporate loans, adjustable-rate mortgages and interest rate swaps. It is also utilized as a credit risk indicator and a benchmark for establishing interest rates on a wide range of financial products. Consequently, LIBOR is closely monitored by investors, financial institutions and regulators in the currency and forex markets.
Phasing Out LIBOR
In recent years, however, LIBOR's credibility has been called into question due to rate-fixing scandals and the decline in interbank lending activity. These concerns have led to a concerted effort to identify and transition to alternative reference rates that offer greater transparency and reduced vulnerability to manipulation. For instance, the United States has proposed the Secured Overnight Financing Rate (SOFR) as a potential replacement while the United Kingdom has recommended the Sterling Overnight Index Average (SONIA) as an alternative for the British Pound Sterling LIBOR.
Final Thoughts on LIBOR
The shift away from LIBOR is anticipated to occur over several years with the majority of LIBOR rates slated for phase-out by the end of 2021. This transition will have widespread implications for the currency and forex markets, as financial institutions and market participants adapt to new reference rates and adjust their risk management strategies accordingly.
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Related Investment Terms
Currency Risk
Interest Rate Risk
Forex
