Question

What is LIBOR, how is it used and why is it problematic?

Answer 1

Ans->
1) LIBOR, the acronym for london interbank offer rate,is the global reference rate for unsecured short-term borrowing in the interbank market.it acts as a benchmark for short-term interest rates.it is used for pricing of interest rate swaps,currency rate swaps as well as mortgages.it is an indicator of the health of the financial system and provides an idea of the trajectory of impending poliy rates of central banks.LIBOR is administered by the Intercontinental Exchange or ICE.
2) It is computed for five currencies with seven different maturities ranging from overnight to a year. The five currencies for which LIBOR is computed are Swiss franc, euro, pound sterling, Japanese yen and US dollar. ICE benchmark administration consists of 11 to 18 banks that contribute for each currency.The rates received from the banks are arranged in descending order and the top and bottom quartiles are excluded to remove outliers. The arithmetic mean of the remaining data is then computed to get the LIBOR rate.
3) The process is repeated for each of the 5 currencies and 7 maturities, thereby producing 35 reference rates. 3 month LIBOR is the most commonly used reference rate.Suppose a corporation issued a six-month floating rate note linked to LIBOR. On each coupon date, the coupon amount will be computed as the par value of the note time one half of the 6 month coupon rate quoted 6 months earlier. Assuming that the prior six months, LIBOR rate is 4 per cent and the par value of the note is 100 pounds, the coupon amount at present will be 100time(4%/2) which is equal to 2.Before ICE, LIBOR was set by British Bankers Association (BBA) but the rigging and manipulation of LIBOR during the financial crisis of 2008 has led the financial market watchdogs to replace the BBA LIBOR with a new administrator. On the basis of Wheatley Review Recommendation, the Hogg Tendering Advisory Committee selected a new entity called the Intercontinental Exchange for the administration of LIBOR. The new administrator became operational from February, 2014

Problem In LIBOR,
The underlying market LIBOR measures is no longer liquid. LIBOR is often used to hedge the general level of interest rates, for which it is inefficient given it includes a term bank credit component. The FCA has secured panel bank support to continue submitting to LIBOR, but only until 2021.