Question

What’s LIBOR? Why is it so popular for determining various loan rates?

Answer 1

LIBOR is short for London Inter Bank Offer Rate. Banks usually own many securities and bonds issued by various borrowers at different rates. The value of those bonds and securities fluctuates as interest rates change. For example, say interest rates increase and then value of bonds decreases in opposite direction. Consequently banks face loss in billions.

This is the common issue faced by all banks and banks want to redeem from this issue and therefore, the solution is with hedge. Yes, that’s right. Banks make contract with financial markets to make hedging contracts which helps banks in the situation of interest rates rise.

In order to protect banks from this interest rates rise, LIBOR comes in. Overtime, banks realized that they need hedge that tracks rates of borrowings and interest rates. Overtimes banks have also realized and understood that Eurodollar contract essentially LIBOR is easy for them to hedge. For banks it is incredibly easy to make hedge.