Why do we care about Libor?

Background

The London Interbank Offered Rate (Libor) is the expected interest rate for leading banks in London to borrow money from other banks. Libor rates are calculated for five currencies and seven borrowing periods ranging from overnight to one year. It is considered to be the most important number in the financial world because at least $350 trillion in derivatives and other financial products are tied to it. (Article)

The Libor was invented by Minoz Zombanakis, who tried to let banks lend $80 million to the cash-strapped Iran in 1969. Banks hesitated to lend money at a fixed rate for long periods, because of the rising inflation in UK. Zombanakis offered a solution in which the interest rate would be recalculated every few months. He marketed the deal to a variety of local and foreign banks that could each take a slice, and the banks in the syndicate would report their funding costs just before a loan-rollover date. The weighted average plus a spread for profit became the price of the loan for the next period, and the rate was called London interbank offered rate (Article).

In 1984, the British Bankers’ Association (BBA) established the BBA standard for interest rate swaps including the fixing of BBA interest-settlement rate, which was later officially called BBA Libor in 1986.

Importance

As the growth of global financial market, Libor had changed from being a tool to price individual loans and bonds to being a benchmark for derivatives deals worth trillions of dollars. The interest rate swap was invented based on Libor during a period of high volatility in interest rates during the 1970s. It allows companies to mitigate the interest rate risk, and traders to speculate on interest rate moves in a cheaper way.

Libor is currently used as the benchmark for mortgages, student loans, interest rate derivatives (Eurodollar, interest rate swaps, future contracts), and corporate funding. It also offers a fair idea to central bank and other institutions about the expectations on interest rates in the market.

Manipulation

Libor was set by a self-selected, self-policing committee of the world’s largest banks. Every morning, banks submitted their estimates, an average was taken, and a number was published in the noon. It was considered hard to be manipulated because the highest and lowest several responses were thrown out when calculating the average rate. However, it was not that hard in reality. Individuals responsible for making their bank’s daily submission often asked brokers to know the borrowing cost. In the case of Tom Hayes, he used his network of brokers to provide his desired rates to bankers, and then influenced the Libor rate. (Article). After 2007-08 financial crisis, many banks were fined by regulators because of their Libor manipulations, including Deutsche Bank, UBS, RBS, etc. (Article)

On Feb. 1^st, 2014, The BBA transferred responsibility for Libor to ICE Benchmark Association which brought more transparency, as well as a robust oversight and governance framework. Most banks now use OIS rate as funding cost of collateralized derivatives, while the Libor rate is still used as the average borrowing cost for non-collateralized derivatives.

Predictive Models

There are two categories of interest rate models: short rate models and forward rate models. The short rate models (e.g., Hull-White, Black-Derman-Toy) describe the evolution of the instantaneous interest rate as stochastic processes, and the forward rate models (e.g., Libor Market Model) capture the dynamics of the whole forward rate curve.