The Basics

LIBOR? What’s that?

If you’ve been paying much attention to the markets of late you probably heard something about LIBOR in relation to the ongoing credit issues that are impacting not only the US, but also Europe and elsewhere. So what exactly is this mysterious thing?

Here’s a definition from the British Bankers Association:

“Libor stands for the London Interbank Offered Rate and is the rate of interest at which banks borrow funds from each other, in marketable size, in the London interbank market.”

For the purposes of our discussion, LIBOR is the overseas rate for US Dollars. It’s basically equivalent to the Fed Funds market between banks domestically. The difference is that it deals in terms of Dollars on deposit outside the U.S. – eurodollars. Which brings us to another market.

Eurodollar futures are based on the 3mo LIBOR rate. For example, the September Eurodollar futures will be valued at 100 (par) minus the 3 month LIBOR rate when it expires (Sep. 17th, right before the Fed meeting). So for example if LIBOR (specifically the BBA’s fixing that day) is at 5% that day, the Eurodollars will be priced at 95.

The issue that has made big news of late is that LIBOR has been running very high, much higher than the Eurodollar futures. For example, on Sept. 5th the LIBOR rate was 5.72% and Sep. Eurodollars were at 94.44 (down from a high of about 95.00 on August 21st). The LIBOR rate implies 94.28 Eurodollars. Those two must converge by the 17th. The question folks in the market have been asking is which one of those markets is correct.

Just like in Fed Funds a short while back and Commercial Paper, the LIBOR rate has been under upward pressure because of counterparty credit concerns. To put it simply, the banks and such that operate in the LIBOR market don’t have a lot of trust thanks to issues related to sub-prime, so are pricing a risk premium into the rate at which they are willing to lend overnight funds.

A related subject is the so-called TED spread. That’s the T-Bill/Eurodollar spread. Once upon a time it was a fairly common discussion point and even an oft traded futures spread. For many years, though, the spread was tight and not very volatile. The flight to quality into T-Bills recently, however, has caused that spread to become much more interesting. As a result, you’re hearing about it in the news once more.

By John

Author of The Essentials of Trading