Understanding LIBOR: London Interbank Offered Rate

LIBOR, or the London Interbank Offered Rate, is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans. It serves as a global reference rate for various financial instruments including mortgages, loans, and bonds.

How is LIBOR Determined?

LIBOR is calculated and published daily by the Intercontinental Exchange (ICE) based on submissions from a panel of banks. It reflects the average rate at which banks estimate they could borrow from each other. It's published for five currencies (USD, EUR, GBP, JPY, and CHF) and for seven different maturities (overnight, one week, one month, two months, three months, six months, and 12 months).

Examples of LIBOR Use

Example 1: In adjustable-rate mortgages (ARMs), the interest rate is often tied to LIBOR. If LIBOR increases, the interest rates on these mortgages also increase, raising the monthly payments.

Example 2: For a business loan with an interest rate of LIBOR + 2%, if the 3-month LIBOR rate is 1%, the loan's interest rate would be 3% (1% LIBOR rate + 2% margin).

Transition from LIBOR

Due to concerns over the reliability and robustness of LIBOR, a global transition to alternative reference rates is underway. In the United States, the Alternative Reference Rates Committee (ARRC) has proposed the Secured Overnight Financing Rate (SOFR) as a replacement for the USD LIBOR.

Impact of the Transition

The shift from LIBOR to alternative rates like SOFR impacts financial products tied to this benchmark. Institutions and individuals with LIBOR-based financial instruments need to prepare for the changes in interest rate calculations and contract terms.

Conclusion

LIBOR has been a cornerstone of the global financial system, but its phasing out marks a significant shift. Understanding this transition and its implications is crucial for both institutions and consumers involved in LIBOR-tied financial products.