Question

Please discuss how does manipulation of LIBOR interactively influence the OTC derivative market (You need to use a real example to support the discussions).

Answer 1

Derivatives - These are contracts which derive their values from the value of one or more of other assets (Known as underlying Assets). Underlying assets include securities, foreign exchange, interest bearing securities and commodities. The derivatives are most modern financial instrument in hedging risk. These can be further classified into 2 categories :- a) Listed b) OTC - Over the counter Derivative.

OTC Derivative trades off the Exchange & can be modified/tailored to each party needs. These are private contracts that are traded between two parties with out going through an exchange or other intermediaries. This type of derivative offers flexibility, it pooses credit because it is not traded through exchanges.

LIBOR - It stands for London Interbank Offered rate is a bench mark rate that some of world's leading bank charge each other for short term loans.

LIBOR interactively influence the OTC Derivative Market

1) OTC interest rate derivative set terms for exchange of cash payment based on change in market interest rate.

2) Like in FRA (Forward rate Agreement) that set terms for exchange of cash payment based on changes in LIBOR.

For Example - Suppose 2 banks enter into an agreement specifying: – a forward rate of 5 percent on a Eurodollar deposit with a 3-month maturity

– A $1 million notional principal - 1 month Settlement.

Such agreement termed 1 × 4 FRA because it fixes the interest rate for a deposit to be placed after 1 month and maturing 4 months after the date the contract is negotiated.

If 3 months LIBOR is 6%.

Then Seller owe the buyer the Difference of 6% & 5% on $1Million for 90 days period.

Every 1 basis Point change in interest rate payable on Principal $1M for 90 day interest cost by $25($10,00,000 x 0.01%(1 Basis Point) x 90/360).

So, Increase in 100 basis point i,e 1% on 3 month EuroDollar deposit over the specified forward rate in this case is $25 x 100 basis point = $2,500.

The $2,500 Difference in interest cost calucated is to be discounted back 3 Months using the actual 3 months LIBOR prevailing on settlement date.

Thus,if 90 day LIBOR turns out to be 6% on the contract maturity date the buyer would receive =

$2,463.05 = $2,500/ [1 + 0.06(90/360)].

Final settlement of amount owed by the parties to an FRA is determined by the formula ;-

Payment = (N) (LIBOR - FR) (dtm/360)/ 1 + LIBOR (dtm/360)

Where

N = Notional Principal Agreement amount.

LIBOR = LIBOR Value for the maturity specified by the contract prevailing on the contract settlement date.

FR = the agreed-upon forward rate.

dtm = maturity of the forward rate, specified in days.

Conclusion :- If LIBOR > FR the seller owes the payment to the buyer, and if LIBOR < FR the buyer owes the seller the absolute value of the payment amount determined by the above formula.