What is LIBOR? For what is it? How is calculated? And how does it affected the interest swaps
The Eurodollar future contract is one of the largest and most successful interest rate based contract.
Eurodollar is interest rated product and should not be confused with the currency of the European
Union, which is known as the Euro (€). The Eurodollar and the Euro are not the same things,
eurodollar is the term that is referred to any united stated dollar held outside of the USA banking
system. In other words, there can be eurodollars in the UK or UAE or they exist even in Brazil or
Djibouti, even the USA is held in a branch of a foreign bank. The point is that the term eurodollar
referred to the dollars outside of the US banking system and not their geographical location. The
eurodollar market developed after WW2 when recovering economies gradually begin to accumulate
on to US dollars. Some countries preferred not to reappropriated the US dollars through the US
banks but instead held them offshore primarily in London-based banks out of the reach of the
United States Government. Over time a bank lending market grew up around this pool of funds,
British bankers began referring to the lending rate and this market as the London Inter-Bank Offer
Rate, also known as the LIBOR. Libor has grown into a set of rates across the length of the yield
curve, from overnight to 12 months. CME group eurodollar futures contracts are based on the 3-
month Libor underlying rate. Eurodollar futures contracts are listed under the march quarterly cycle
for forty consecutive quarters, also four serial contracts at the front end of the curve. They are
financially settled products and they expire on the second business day that precedes the third
wends day of each contract month, this is usually a Monday. Eurodollar futures contracts are used
by a wider rate of users from banks to privately trader funds, and commercial business to hedge
funds. So if you have US dollar markets exposure eurodollar future can help to manage the risk.
However, LIBOR is compiled in a different, comparable way. The panel banks are asked every
morning for what fee these banks are willing to lend money to other banks. Whether the banks lent
money at this interest rate is irrelevant (in contrast to the Euribor and EONIA). For each time period,
the lowest interest rate at which a bank would like to lend money to another bank is examined. The
LIBOR is calculated on this basis. The BBA, the organization behind LIBOR, indicates that for that
currency it would not be possible to calculate LIBOR daily based on the actual transactions because
there is not a need to borrow large sums of money every day. Nevertheless, the organization does
see LIBOR as a representative rate, since banks would quote real prices. As with Euribor, an average
interest rate is calculated for LIBOR. With the Euro LIBOR, 15-panel banks are asked at what interest
rate they are willing to lend money. The four highest and the four lowest rates are subsequently
scrapped. An average is calculated for the seven remaining rates. This average is then published.
Banks must report rates to Thompson Reuters between 11 a.m. and 11:10 a.m. daily. They calculate
the following average LIBOR interest for the different currencies and then publish it.
The banks are chosen based on several criteria. For example, the activity of the relevant bank on the
market, the credit rating, and the assumed expertise in the relevant currency are examined. For the
euro, 15 banks are being considered, including Rabobank from the Netherlands.
, In the typical interest rate swap, one party exchanges fixed-rate payments for variable-rate interest
payments. The variable interest is based on LIBOR. Whoever agrees to make interest payments
hopes the rates will go up because that means it will now pay less interest than it will receive from
its counterparty in the swap contract. The opposite is true for the party who agrees to pay the
variable interest.
The LIBOR scandal affected interest rate swaps in two main ways. In the period 2005-2009, more
than a dozen major financial institutions manipulated the base LIBOR figure for LIBOR-linked
derivatives products, including interest rate swaps. Some swaps traders would have asked
employees to Barclays to submit rates that would benefit the merchants rather than rates that the
bank would normally have paid to borrow money. These actions led, among other things, to large-
scale investigations and criminal punishment for linking interest rates by these banks.
Libor the 350 trillion dollar benchmark interest rate, and its disappearance will create an disruption.
Libor will be replaced by the following: UK its SONIA the Sterling overnight index average
Switzerland will use SARON the swiss average rate overnight
Japan will use TONA Tokyo overnight average rate
U.S. it’s SOFR secure overnight financing rate
Eurozone selected ester the euro short-term rate
So let's briefly talk about the advance each rate has accomplished on its path to the 2021 deadline of
LIBOR anticipated demise. They ampere for most advanced and progressed at least, so let's begin
with SONIA. Of all the five rates SONIA has made the most progress it was selected as the alternative
rate to GDB LIBOR in April 2017 and today swap volume reference SONIA are quite strong with
SONIA's future also gain steam. This year anticipated that term reference rates for SONIA will start to
be republicized and that the fallback language will be agreed upon for current contracts. Next is
SARON it was selected as the alternative rate for CHF LIBOR in October 2017 swaps that reference
SARON started clearing in December 2017 and future that reference stared clearings in October
2018 fallback languages are currently being considered before the shot-term rate can be created
liquidity for SARON product continues to need to strengthen. TONA has achieved similar momentum
to SARON it was selected in December 2016 as the alternative rate to JPY LIBOR, TONA is already
used as the reference rate for overnight market japan the current task is to build up the liquidity of
TONA products so hat term reference rates can be created. fourth is SOFR it was selected in June
2017 as the alternate rate to the USD LIBOR and was published in 2018. So first swaps and future
started clearing mid-2018 but liquidity in SOFR is weak, but a detailed and clear transition plan from
libor o SOFR is in place. The publication of SOFR term rates isn’t expected until the end of 2021.
Esther has the least momentum of all the five rates and was only recently identified as the
alternative to EONIA and EURIBOR, October 2019 is the date that ESTER daily rate was published.
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