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Saturday, September 17, 2011

THE LIBOR and its’ importance in Economics

London Interbank Offered Rate – LIBOR

With all of the economic stability taking place throughout the world it is not unusual to hear discussions involving something known as LIBOR.  What the heck is a LIBOR and why should I care?

The LIBOR is the world's most widely used benchmark for short-term (one day to five years) interest rates. Think of it as the interest rate that the banks charge each other for loans (usually in Eurodollars).

Why is it important? Because this is the rate at which the world's most preferred borrowers are able to borrow money.  In addition, it’s also the rate upon which rates for less preferred borrowers are based. A good example would be a large multinational corporation with a very solid credit rating having the ability to borrow money for one year at LIBOR plus four or five points.

The LIBOR is officially fixed on a daily basis by a small group of large London banks, known as the British Bankers' Association (BBA) but the rate changes throughout the day.

The LIBOR is also widely used as a reference rate for financial instruments such as forward rate agreements, short-term-interest-rate futures contracts, variable rate mortgages, currencies, especially the US dollar and several other financial instruments.

Back in 1984, an increasing number of banks were trading actively in a variety of fairly new market instruments, such as: interest rate swaps, foreign currency options and forward rate agreements. While such instruments brought more business London Interbank market, bankers were concerned that future growth could be hampered without some measure of uniformity.  In October 1984 the British Bankers' Association (BBA) —working with other parties, -- established various working parties. They eventually produced the BBA standard for interest rate swaps. Part of this standard included fixing BBA interest-settlement rates, which was the predecessor of BBA LIBOR. 

Rate calculations are derived by 16 of the world's most creditworthy banks' across 10 currencies and 15 lending periods ranging from overnight to one full year. These calculations incorporate variables such as time, maturity and currency rates. There are hundreds of LIBOR rates reported each month in numerous currencies. 

BBA LIBOR fixings did not commence officially before 1 January 1986. Before then, some rates were fixed for a trial period beginning in December 1984.

Countries that rely on the LIBOR for a reference rate include the United States, Canada, Switzerland and the U.K.

How Does All of This Affect Me?

Although the LIBOR rates are fixed in the United Kingdom, American consumers can benefit by having a greater understanding of how LIBOR works, since LIBOR is used as an index in the pricing of many kinds of consumer loans in the United States.

Chances are that adjustable rate mortgages and credit card interest rates are based on LIBOR. As rates reset, the high LIBOR will make your monthly payment also higher. It is estimated that 60% of all adjustable loans within the United States are tied to the LIBOR.

If that wasn’t enough consider the fact that student loans are also pegged to the interest rate charged to the LIBOR. If rates go up the loan will become more expensive. As if getting a college education wasn’t financially draining already.

In addition to ARM mortgages, your credit card debt is affected by the LIBOR rate.

A risking LIBOR will make many types of consumer and business loans more expensive.  When this happens, more money is taken out of the economy, slowing growth and increasing unemployment.

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