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I am just starting on Interest Rate Swaps & curve construction. While reading few materials on Interest Rate Swap, it's indicated for e.g. "Floating Coupon Index: 6 month USD LIBOR".

LIBOR is the London Inter Bank Overnight Rate. How does it matter for USD? If a security is USD denominated, shouldn't it be valued using some USD based interest rate e.g. Treasury security rates? Why does USD based security valuation have to give a thing about what London Banks think? US still remains the largest bond market in the world...though. Even following link states USD LIBOR is what London banks prepared to lend $$$.00...

It doesn't seem to stop there, as couple of other currencies have their LIBORs available as well. Why there has to be a USD LIBOR in the first place?

  • Reference:

The US Dollar LIBOR interest rate is the average interbank interest rate at which a large number of banks on the London money market are prepared to lend one another unsecured funds denominated in US Dollars. The US Dollar (USD) LIBOR interest rate is available in 7 maturities, from overnight (on a daily basis) to 12 months. The US dollar LIBOR interest rate serves as a base rate for all sorts of other products such as savings accounts, mortgages and loans. Alongside the US Dollar LIBOR there are also LIBOR interest rates in 4 other currencies...

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@quantycuenta a one liner wouldn't satify me - unless the one liner has a calculation/formula that could can be plugged in with numbers to make sense. Not to mention the Libor scandal –  bonCodigo May 23 at 0:53
    
Yes, it was a comment not an answer yet sufficient to determine why LIBOR is so important. You could also look at the price controls and quotas on credit trading from the 1970s in the US that have only been partially repealed. One little scandal has done nothing to dampen reality just as the US stock market hasn't been obliterated by WorldCom, ENRON, Madoff, Ponzi... –  user6500 May 23 at 1:02
    
Awesome insights and "LIE-bor-ed"! Well, when you said fed-fund target rate and b, are you reffering to BBA or banks by b? Could the poor credibility of Libor has infact given momentum to modern customized rate curves used in banks' FI/Credit/MM desks? –  bonCodigo May 23 at 6:04
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I added my own answer, hence built my earlier comments above into my answer. –  Matt Wolf May 23 at 6:19

2 Answers 2

up vote 2 down vote accepted

The importance here is that it actually does not matter in what time zone or market the libor rates are set. Key is that it is supposed (!!!) to be a gauge at what rate contributing banks could borrow funds at in the inter-bank market. Like you can go to any African country and borrow or lend US dollar, so can any Japanese, European, or American bank borrow and lend US dollar in either New York, London, or any other money center. London was chosen out of convenience because it has traditionally been accepted as a convenient time zone (vs Japan or the US) for international trade, such as currency exchange and for many international fixed income asset classes.

The importance of Lie-bor has been greatly diminished due to the following, however:

  • Due to the most recent rate setting scandal
  • Because of the changes in dynamics in the money and rates market (a. increased market focus on IOER and RRP rates rather than fed fund target rate,and b. the Fed will possibly change its policy rate to RRP)
  • Because the current low spread of libor over top-tier CP begs a lot of questions as to whether libor adequately reflects the risk it is suppose to price (given historical context of the spread). The market right now scrambles at deciding whether this is the new normal or not.
  • Some research points to recommendations that OIS should not only be used as "risk-free rate" (this term imho should actually be removed from all textbooks) for collateralized portfolios but also uncollateralized ones, in effect replacing libor as curve input.

The biggest change I see and hear fixed income traders talk about is the new ways curves are constructed. The point is that libor itself is of decreasing importance actually. It is the curves that result from adding certain spreads on top of libor curves that matter. If market consensus now shifts to sourcing different rates to construct the base curve then libor rate usage will be phased out gradually.

But keep in mind that a huge amount of derivatives and outstanding rates and even credit products are still based on libor, hence this is not something that will change overnight.

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+1 and accepted! Quoting: It is the curves that result from adding certain spreads on top of libor curves that matter. : This is exactly what I am after as I am on the exercises for curve construction in the context of IRS. I have couple of question on forward rates and IR relationship and some jargons which are not cleared by online materials. I am on Fabozzi's FI and Tuckman's FI books. I hope to get in touch with your great knowledge and insights. –  bonCodigo May 23 at 8:07
    
I am one of the users with least knowledge of curve construction, there are true experts on this site, addressing this or future curve related questions. –  Matt Wolf May 23 at 8:54

Why does USD based security valuation have to give a thing about what London Banks think?

Your question is based on false premises: the USD Libor is not determined by polling London based banks as you seem to believe, but banks on the London money market. The difference is important, as there are—of course—banks which are not based in London and active on the London money market.

The USD panel has the following members:

  • Bank of America
  • Bank of Tokyo-Mitsubishi UFJ Ltd
  • Barclays Bank plc
  • BNP Paribas
  • Citibank NA
  • Credit Agricole CIB
  • Credit Suisse
  • Deutsche Bank AG
  • HSBC
  • JP Morgan Chase
  • Lloyds Banking Group
  • Rabobank
  • Royal Bank of Canada
  • Société Générale
  • Sumitomo Mitsui Banking Corporation
  • The Norinchukin Bank
  • The Royal Bank of Scotland Group
  • UBS AG

If these banks are in the panel, one can assume that their activity on the London money market is particularly relevant for USD securities. As we see, many of them are neither based in London or the UK nor in the US.

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Clarified & European banks are rich. I didn't not mean UK in the sense by London. Well I must correct the question as I was pointing at Europe. However the main underlying doubt was about using rates that are not based on the market/country of domicile of these interst rates/bond securities. –  bonCodigo May 23 at 5:56

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