What is LIBOR Curve?
LIBOR curve represents graphically, the values of the LIBOR rate at various maturity intervals such as one-month rate, two-month rate, etc and it is used by various banks and other financial institutions for determining the interest rate for debt-based products and other financial products.
Example of LIBOR Curve
Let us have a look at an example of a one-year LIBOR Curve of the year 2019.
The curve is based on the following data.
The curve here represents the movement in the LIBOR interest rateLIBOR Interest RateLIBOR 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. on a monthly basis. The rates for a period of twelve months is depicted in the graph. By having a look at the graph, the LIBOR rate for all twelve months can be determined.
Uses of LIBOR Curve
- LIBOR curve is the benchmark rate on a global level used by the leading banks, financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. , and credit rating agencies for determining the interest rate for short-term borrowings. The rate is being used by the financial institutions for determining the interest rate for various debt products such as corporate loans, bonds, credit cards, security-based loans, etc. Also, the use of the LIBOR rate is not limited to debt-based products since the same is also used for other products such as derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. .
- It is important to note that the LIBOR rate represents the lowest rate of lending, and the rate of interest is represented above this rate. For example, when it is quoted that the rate of interest is “LIBOR + X basis points,” then it means the financial institution is charging x% of premium above the LIBOR rate to its borrower. Whenever the LIBOR base rate changes, the lending rate will also fluctuate. This is the reason why the LIBOR rate is known as a floating rate of interest.
- Further, the LIBOR rate is also helpful in interest rate futures contracts, for setting up the settlement price, which wherein, which helps the party to the contract to protect itself from the interest rate fluctuations. Also, other beneficiaries have an idea of expected interest rates based on the LIBOR rate.
Importance of LIBOR Curve
LIBOR curve is an important tool for banks and financial institutions and is based on the globally determined benchmark rate. The same is useful for determining the interest rates for lending and other financial products such as interest rate swapsInterest Rate SwapsAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate. and LIBOR futures. A majority of global financial products are based on LIBOR. The rate is also used by the regulatory authorities to suggest the maximum spread at which loans can be given to the borrowers abroad.
LIBOR Curve vs. Swap Curve
- LIBOR curve represents the maturities of the LIBOR rate over a graph, and its maturities are for a period of intervals of less than a year. LIBOR rates are being calculated, and the result is published every day by an organization named ICE (Intercontinental Exchange). The rate is based on the five major currencies. Namely, US Dollar, British Pound, Euro, Japanese Yen, and Swiss Franc, and the rate is represented for a total of seven maturities, namely spot, one week, one month, two months, three months, six months, and twelve months.
- On the other hand, the Swap curve represents the swap ratesSwap Curve Represents The Swap RatesSwap rate refers to the fixed exchange rate of a swap contract as ascertained by the parties or the market. The rate is inclusive or exclusive of the spread and determined on the benchmark rates such as LIBOR or MIBOR. at different levels of maturities. The swap curve indicates the expected rates of return for various maturity periods. The use of the swap curve is mainly in the financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces. and is used by investors. It represents the interest rates expected by the participants of the market. The rate is thereby based on market expectations based on the risks that the participants incur.
LIBOR curve graphically represents the LIBOR rate for various maturities. The rate is being used globally by the leading banks and other financial products and continues to be used to date.
This has been a guide to what is LIBOR Curve. Here we discuss an example of a one-year LIBOR curve with importance, uses, and differences. You may learn more about Financing from the following articles –