Business

LIBOR explained

SSL in the Money

WITH SHANNON HARRIS

Wednesday, June 20, 2018

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“We are in a rising interest rate environment.”

At one point or another in the last two years onward, this statement would have been read or said to anyone remotely interested in the financial markets.

What exactly is meant by interest rate, are there different interest rates and how do they impact investments or the stock market?

In this article, we are going to be focused on one particular set of interest rates, namely the ICE LIBOR, or more commonly referred to as just the LIBOR.

This obscure set of interest rates has far-reaching consequences and is used as the basis for trillions of us dollars of financial instruments, from student loans to the interest charged on credit card payments.

WHAT IS THE LIBOR?

Interest rate refers to the amount charged of the principle, expressed as a percentage, by a lender to a borrower for the use of assets. Interest simply put is the cost of borrowing money. Intercontinental Exchange London Interbank Offered Rate (ICE LIBOR) is a set of daily average rates at which large international banks will lend unsecured sums of cash to each other over a set of tenors or time periods. These rates are in turn used as global benchmarks for other financial transactions such as adjustable rate mortgages.

Essentially, the ICE asks 18 of the largest international banks in London “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11:00 am. This is done for five major currencies the US dollar (USD), British pound (GBP), Euro (EUR), Swiss Franc (CHF) and Japanese Yen (JPY) across seven maturities, namely overnight, one week, and one, two, three, six and 12 months.

It follows that 35 rates are generated and published each day, which can be a tad misleading given the singularity of the name. More often than not, when the LIBOR is referenced it is implied to be the three-month rate unless otherwise specified. The average is calculated using the trimmed arithmetic mean, which removes the highest and lowest quartiles and averages the remaining ten rates.

SIGNIFICANCE OF THE LIBOR

Given the nature of what the LIBOR is, the question becomes how does this affects the individual as these are rates between the institutional players in the market. Banks borrow large sums, of cash and as such will be charged a miniscule rate as opposed to the individual who takes a far smaller sum which in turn means a higher interest rate.

The LIBOR represents the base or the benchmark for further or additional transactions to be done in the secondary market (the market where individual investors find themselves). It forms a part of the building block that will be the final interest rate charged on a student loan or credit card. The term is often referenced in bond and loan documentation, and in a range of derivative instruments such as interest rate swaps and future contracts. It is estimated that north of us$300 trillion dollars' worth of outstanding contracts and deals are linked to the LIBOR.

LIBOR EFFECTS

One particular effect the LIBOR can have on individual investor portfolios is through floating rate securities. This may be a bond or a preferred share which, given its high dividend payment, can be used as a bond proxy.

These instruments can have a component where the interest that is paid is not fixed but changes in respect to a benchmark, plus a few percentage points. For example, a floating rate bond may have a clause which states that the interest paid by the bond is LIBOR + 300 BPS. In other words, this bond pays interest at whatever rate the LIBOR currently is plus 3 per cent. It stands to reason that the particular interest rate risk to this bond would be fluctuation in the LIBOR, which by nature of its composition can be used as an indicator of the health of the financial system during times of economic downturns.

LIBOR VS FED RATE

The LIBOR differs from the Fed fund rate, which is generally the interest rate that is used in the statement “We are in a rising interest rate environment”. That interest rate is a tool of monetary policy used by central banks to limit the money supply in an economy in the aim to prevent it from overheating and keeping the inflation target within range. These rates are published every few weeks following a Federal Open Market Committee. The LIBOR is done daily and gives a current picture of what rates really are within the market.

It is often easy to have a vague understanding of a concept that is almost always denoted in acronym; the LIBOR has far-reaching consequences across financial markets and is just one of a set of global benchmarks. Given the linkages it has to various types of loans, instruments and derivatives in international markets in major currencies, it will remain a staple. Investors should seek a better understanding of the concept as it may have indirect effects on loans to the instruments in your portfolio.

Shannon Harris is a Private Wealth Management Associate at Stocks and Securities Limited.

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