Full Form of LIBOR – London Inter-Bank Offered Rate
The full form of LIBOR is the London Inter-Bank Offered Rate. LIBOR can be defined as an average interest rate at which only the panel international banks can lend unsecured funds (or short term loans) to one another and it is calculated, published and fully administered by the ICE (Intercontinental Exchange) and it is calculated for five currencies like Euro, Swiss Franc, Pound Sterling, US dollar and Japanese Yen.
History of LIBOR
Banking institutions during the early 1980s started to look for an average interest rate for calculating the prices on a wide variety of financial products. British Bankers Association of BBA, for this reason, began to publish London Inter-Bank Offered Rate or LIBOR on 1st January 1986. The idea behind publishing London Inter-Bank Offered Rate was to allow banks to have a uniform interest rate instead of different types of interestDifferent Types Of InterestFixed interest, variable interest, annual percentage rate, prime interest rate, discounted interest rate, simple interest, and compound interest are the most common types of interest. rates charged for different types of loan amounts.
The features of LIBOR are:
- It is calculated for 5 currencies with 7 different maturities that range from overnight to up till a year.
- LIBOR rate is calculated, published and administered by the ICE or Intercontinental Exchange.
- They act as a benchmark or a standard for short term interest rates.
- It is an international reference rate for unsecured funds or short term borrowings in the global interbank market.
- LIBOR has used for the purpose of pricing of mortgages, currency rate swapsCurrency Rate SwapsCurrency Swap is an agreement between the two parties for exchanging notional amount in one currency with that of another currency. It's interest rate can be fixed or floating rates denominated in two currencies. , and interest rate swaps.
- They act as an indicator of the well-being of the overall financial system.
How to Calculate LIBOR?
LIBOR is calculated using trimmed arithmetic mean formulaArithmetic Mean FormulaArithmetic mean denotes the average of all the observations of a data series. It is the aggregate of all the values in a data set divided by the total count of the observations.. This method is used in the case of all the responses that are received. The panel banks struggle every day deciding the rate at which they should borrow funds. This is where the use of the trimmed arithmetic mean method comes into the picture. ICE or Intercontinental Exchange uses the trimmed mean method and excludes the inclusion of extreme interest rates and totals the remaining rates and divides the same by the number in order to derive the benchmark or average interest rate. So, if it is surveyed that there are 20 banks and out of which 10 are extreme or outliers, then this rate for that particular day shall be dependent on the arithmetic mean between the 10 remaining banks.
Example of LIBOR
ABC Limited and XYZ Limited have a common interest rate swap. Both the companies agreed upon exchanging payments pertaining to the interest rates as ABC wants to switch from fixed to variable rate while XYZ wants to switch from variable to fixed rate. ABC Limited has a $2 billion investment.ABC’s investment pays out a floating interest rate which equals LIBOR + 2% per quarter while XYZ’s investment pays out a fixed interest rate of 2.5% each quarter. ABC’s interest rates are variable and so it wants to switch to a fixed interest rate so that it can experience certainty with respect to cost whereas XYZ’s interest rates are fixed and it is willing to accept a floating rate of interest for the purpose of being able to receive higher interest amounts. Both ABC and XYZ can enter into swap agreements where the former shall receive a fixed 2.5% interest for its investment whereas the latter shall receive the floating interest rate of LIBOR + 2% from ABC.
Need of LIBOR
LIBOR is not just considered as an only metric that is used for the purpose of determination of interest rates but it is also regarded as the most significant initial step. They help the panel banks in calculating and publishing interest rates for multiple financial products that include savings accounts, loans, and mortgages too. The international economy has now become more complicated and there are trillions of dollars held by the banking institutions at the moment. This is why the concept of the LIBOR rate was introduced in order to provide a proper way for banking institutions to establish a groundwork for forecasting upcoming future rates.
LIBOR vs LIBID
The difference between LIBOR and LIBID are:
- Full-Form: LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions. stands for London Inter-Bank Offered Rate whereas LIBID stands for London Inter-Bank Bid Rate.
- Meaning: LIBOR can be defined as a standard interest rate at which a selected group of banks choose to lend unsecured funds to one another in the global interbank market or London money market. On the other hand, LIBID can be defined as a standard interest rate at which the major players of the London banks bid for euro-currency deposits from the competitor banks in the global interbank market.
LIBOR is globally regarded as one of the most important benchmarks when it comes to short-term interest rates or unsecured funds. It is used as a base rate in the case of multiple financial products like swapsSwapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest., options, and futures. Panel banks also take use of LIBOR interest rates while calculating the interest rates for mortgages, loans, and savings. They act as an indicator in determining the wellness of the overall financial banking system. It is also taken into use as an international reference rate for processes like product valuation, price discovery, and clearing. LIBOR also accounts for premiums pertaining to the liquidity concerning various instruments that are regularly traded in the money marketsMoney MarketsThe money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability..
LIBOR is the short term used for London Inter-Bank Offered Rate. It can be defined as an international reference rate at which panel banks can borrow unsecured funds from one another on the global interbank market. This rate is calculated, published and administered by the ICE. It is calculated for 5 currencies with 7 different maturities that range from overnight to 12 months. This rate is calculated by using the trimmed arithmetic mean method.
This has been a guide to the Full Form of LIBOR and its definition. Here we discuss how to calculate LIBOR along with an example, features, and differences. You may refer to the following articles to learn more about finance –