LIBOR, or the London InterBank Offered Rate, is a widely used benchmark interest rate that serves as a reference for various financial instruments and transactions worldwide. It is calculated based on submissions from a panel of banks, which represent the rates at which they believe they could borrow funds from each other in the London interbank market.
The calculation of LIBOR involves several steps. First, a panel of banks is selected by the Intercontinental Exchange (ICE), the administrator of LIBOR. These banks are typically large, internationally active financial institutions with significant presence in the London interbank market. The panel consists of banks that are considered to be active participants in the market and have sufficient expertise to provide accurate and reliable submissions.
day, these panel banks are required to submit their estimated borrowing costs for various currencies and tenors. The currencies include the US dollar, euro
, British pound sterling, Japanese yen, and Swiss franc. The tenors represent different loan
maturities, ranging from overnight to one year.
The submissions provided by the panel banks are based on their judgment and experience, considering factors such as prevailing market conditions, liquidity, credit risk, and their own funding needs. The submissions are made before a specified cut-off time and are typically expressed as an average rate after excluding the highest and lowest quartiles.
Once the submissions are received, ICE calculates LIBOR for each currency and tenor by taking the arithmetic mean of the remaining submissions. This calculation methodology aims to eliminate any potential outliers or manipulation attempts by individual banks. The resulting LIBOR rates are then published on ICE's website and disseminated to financial institutions and market participants globally.
Several factors influence the determination of LIBOR. Firstly, market conditions play a crucial role. LIBOR tends to reflect the prevailing interest rates in the London interbank market, which are influenced by factors such as supply and demand dynamics, central bank policies, economic indicators, and geopolitical events. Changes in these factors can lead to fluctuations in LIBOR rates.
Secondly, credit risk is an important consideration. Banks factor in their perception of the creditworthiness of their peers when submitting their borrowing costs. If a bank perceives higher credit risk in the market, it may submit a higher borrowing cost, which can impact the calculated LIBOR rate.
Furthermore, liquidity conditions also affect LIBOR. In times of market stress or tight liquidity, banks may face difficulties in borrowing funds from each other, leading to higher borrowing costs and potentially higher LIBOR rates. Conversely, during periods of ample liquidity, borrowing costs may decrease, resulting in lower LIBOR rates.
Lastly, regulatory changes and market reforms have also influenced the determination of LIBOR. Following the LIBOR manipulation scandal in 2012, regulators have implemented reforms to enhance the integrity and reliability of the benchmark. These reforms include strengthening the governance framework, encouraging the use of transaction-based data for submissions, and promoting the transition to alternative reference rates.
In conclusion, LIBOR is calculated based on submissions from a panel of banks, considering various factors such as market conditions, credit risk, and liquidity. The determination of LIBOR is influenced by the judgment and expertise of the panel banks, as well as regulatory reforms aimed at improving its accuracy and reliability. Understanding the calculation methodology and the factors that influence LIBOR is crucial for participants in financial markets who rely on this benchmark rate for pricing and valuation purposes.