LIBOR, the London Interbank Offered Rate, is the most active interest rate market in the world. It is determined by rates that banks participating in the London money market offer each other for short-term deposits. The number is used in determining the price of many other financial derivatives, including interest rate futures, swaps and Eurodollars. Due to London's importance as a global financial center, LIBOR applies not only to the Pound Sterling, but also to major currencies such as the US Dollar, Swiss Franc, Japanese Yen and Canadian Dollar.
The rate is determined every morning at 11:00am London time by a department of the British Bankers Association, which averages the inter-bank interest rates being offered by its membership. LIBOR is calculated for periods as short as overnight and as long as one year. While the rates banks offer each other vary continuously throughout the day, this specific rate is fixed for the 24 hour period. Generally, the difference between the instantaneous rate and LIBOR is very small, especially for short durations.
The most important financial derivatives related to this rate are Eurodollar futures. Traded at the Chicago Mercantile Exchange (CME), Eurodollars are US dollars deposited at banks outside the United States, primarily in Europe. By holding the deposits outside the country, US depositors are not subject to Federal Reserve margin requirements, allowing higher leverage of the funds. The interest rate paid on Eurodollars is largely determined by LIBOR, and Eurodollar futures provide a way of betting on or hedging against future interest rate changes.
Interest rate swaps are another significant financial derivative dependent on LIBOR. In an interest rate swap, two parties exchange sets of interest payments on a given amount of capital. Generally, one party will have a fixed interest payment, while the other will have a variable rate. The variable rate payment stream is often defined in terms of LIBOR. Interest rate swaps are extremely important in providing a liquid secondary market for residential mortgages, which in turn allows lower interest rates on US mortgages.
While LIBOR does have implications for transactions conducted in Euros, the advent of this currency has brought with it the creation of the Euribor. Conceptually similar, the Euribor benchmark is defined and maintained by the European Banking Federation.
