Full Form of LIBOR

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WallStreetMojo Team

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Ashish Kumar Srivastav

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Dheeraj Vaidya, CFA, FRM

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Full Form of LIBOR - London Inter-Bank Offered Rate

The full form of LIBOR is the London Interbank Offered Rate. LIBOR can be defined as an average interest rate at which only the panel of international banks can lend unsecured funds (or short-term loans) to one another. 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.

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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. The British Bankers Association of BBA, for this reason, began to publish the London Interbank Offered Rate or LIBOR on 1st January 1986. The London Interbank Offered Rate idea was to allow banks to have a uniform interest rate instead of different interest rates charged for different loan amounts.

Full-Form-of-LIBOR

Features

The features of LIBOR are:

  • It is calculated for five currencies with seven different maturities that range from overnight to up to 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 been used to price mortgages, currency rate swaps, 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 formula. This method is used in the case of all the received responses. The panel banks struggle every day deciding the rate at which they should borrow funds. The use of the trimmed arithmetic means method comes into the picture. ICE or Intercontinental Exchange uses the trimmed mean method, excludes excessive interest rates, totals the remaining rates, and divides the same by the number to derive the benchmark or average interest rate. So, if it is surveyed that there are 20 banks and out of which ten are extreme or outliers, then this rate for that particular day shall be dependent on the arithmetic mean between the ten remaining banks.

Example of LIBOR

LIBOR example

ABC Limited and XYZ Limited have a common interest rate swap. Both the companies agreed upon exchanging payments about the interest rates as ABC wants to switch from fixed to variable rate while XYZ wants to switch from variable to fixed rate. 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. 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 concerning cost, whereas XYZ's interest rates are fixed. It is willing to accept a floating interest rate to receive higher interest amounts.

Need of LIBOR

LIBOR is not just considered the only metric used to determine interest rates, but it is also regarded as the most significant initial step. They help the panel banks calculate and publish interest rates for multiple financial products, including savings accounts, loans, and mortgages. The international economy has become more complicated, and there are trillions of dollars held by the banking institutions. The LIBOR rate concept was introduced 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: LIBOR stands for London Interbank Offered Rate, whereas LIBID stands for London Interbank 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.

Importance

LIBOR is globally regarded as one of the most important benchmarks for short-term interest rates or unsecured funds. It is used as a base rate in the case of multiple financial products like swaps, options, and futures. Panel banks also use 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 used as an international reference rate for product valuation, price discovery, and clearing processes. LIBOR also accounts for premiums about the liquidity concerning various instruments regularly traded in the money markets.

Conclusion

LIBOR is the short term used for London Interbank 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 five currencies with seven maturities ranging from overnight to 12 months. This rate is calculated by using the trimmed arithmetic mean method.