Finance

What is LIBOR and how it is calculated?

What is LIBOR?

The London Interbank Offered Rate (LIBOR) is an interest rate at which banks lend to each other in the international interbank market for short-term loans. LIBOR is the lowest rate at which the banks lend to each other. It is considered as a globally accepted reference rate for short term borrowings.

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LIBOR is based on five currencies which are US dollar (USD), Euro (EUR), British pound sterling (GBP), Japanese yen (JPY) and Swiss franc (CHF). It has seven different maturities i.e. overnight, one week, one month, two months, three months, six months, and twelve months.

The combination of the five currencies and seven maturities, thereby a total of 35 different LIBOR rates. Three-month LIBOR rate is usually quoted and is referred to as the current LIBOR rate.

As can be seen in the screenshot below the LIBOR rate for GBP as on 8th April 2020 for all 7 different maturities.

 

LIBOR is also considered as a benchmark rate for consumer loans across the world. The change in LIBOR affects not only the financial institution but also consumers. Various loans that are based on interbank rates are credit card loans, car loans, floating-rate mortgages, etc.

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How is LIBOR Calculated?

LIBOR is calculated as a trimmed average rate provided by each panel of banks that submit the rate for the respective currency. For example, 17 major banks like Bank of America, Barclays, Citibank, and JPMorgan Chase, etc. constitute the panel for US dollar LIBOR. The banks that play a substantial role in the London market are only considered in this panel.

Initially for submission of rates ‘LIBOR submission question’ methodology was used, later from mid-2018 ‘waterfall methodology’ was introduced. However, from 1st April 2019, all the banks have to mandatorily submit their rates as per the waterfall methodology.

I. LIBOR submission question

Each day, Intercontinental Exchange (ICE) asks major global banks “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?”

ICE excludes the highest and lowest figures, then calculates the average from the remaining numbers. This is known as the truncated arithmetic mean. Each business day the LIBOR rates are posted in the morning. These quoted rates are annual interest rates. For example: If the survey has 18 banks, the top 4 banks and bottom 4 banks are outliers, the LIBOR rate for that day would be based on the arithmetic average mean of the remaining 10 banks. Once the rates are finalized for all the five currencies and seven maturities these rates are published once a day at around 11:55 am London time.

II. Waterfall methodology

The waterfall method is more transactional and data-driven as it requires submissions to be based on eligible wholesale, unsecured funding transactions.

This method considers three bases for a bank’s rate submission which are:

Level 1: Transaction-based i.e. where a panel bank has eligible transactions that weigh higher and that are booked closer to 11:00 am London Time at a volume-weighted average price (“VWAP”).

Level 2: Transaction-derived i.e. where a panel bank has insufficient eligible transactions and it cannot make Level 1 submission, then it will make a submission based on transaction-derived data.

Level 3: Expert judgment i.e. where a panel bank has insufficient Level 1 or Level 2 data for submission, then it will submit the rate at which it can fund itself at 11.00 am London time for unsecured wholesale funding market. The rate is determined as per the bank’s own internally approved procedure.

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Author: Swati Krishnamurthy

About the Author:

Swati is a freelance writer. She is a Financial Quality Compliance specialist having integrated knowledge and experience in Logistics, Audit, and Risk-mitigation for manufacturing and service sectors. Her passion for finance grew as she scored centum in financial management during her master’s degree. She’s a classical dancer who performs to express complex emotions through her dancing and writes to express complex concepts into simple words.

 

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