Question

1. a) Why does LIBOR receive so much attention in the global financial markets?

b) Why were LIBOR rates so much higher than Treasury yields in 2007 and 2008? What is needed to return LIBOR rates to the lower, more stable levels of the past?

c) What were the three key elements of the package used by the U.S. government to resolve the 2008–2009 credit crisis?

d) Why has the case of Portugal been termed a “case of contagion” rather than a sovereign debt crisis?

e) What’s is a sovereign default?

Answer 1

Ans A) LIBOR is one of the most widely used benchmarks for determining short term interest rates across world.It stands for Intercontinental Exchange London Interbank Offered Rate. It indicates the average rate at which large banks in London can borrow unsecured short term loans from other banks. The rate is given in five major currencies for seven different maturities, the three month US dollar rate being the most common.

Uses of LIBOR

Lenders, including banks and other financial institutions, use LIBOR as the benchmark reference for determining interest rate for various debt instruments. It is also used as a benchmark rate for mortgages, corporate loans, government bonds, credit cards, student loans in various countries. Apart from debt instruments, LIBOR is also used for other financial products like derivatives including interest rate swaps or currency swaps.

The very concept of issuing a floating rate debt instrument is to hedge against the interest rate exposure. If it is a fixed interest rate bond, the borrower will benefit if the market interest rate rises and the lender will benefit if the market interest rate falls. In order to protect themselves from this fluctuation in the market interest rates, the parties to the debt instrument use a floating rate determined by a benchmark base rate plus a fixed spread. This benchmark can be any rate; however, LIBOR is one of the most commonly used ones.

Ans B) In April 2008, the three-month Libor rose to 2.9%, even as the Federal Reserve lowered the fed funds rate to 2%. That was after the Fed had aggressively dropped the rate six times in the previous seven months. The current fed funds rate has experienced drops in 2019, but not as aggressively as it did in 2008.

It's because banks started to panic when the Fed bailed out Bear Stearns, which was going bankrupt due to investments in subprime mortgages. Throughout the spring and summer, bankers became more hesitant to lend to each other. They were afraid of the collateral that included subprime mortgages. Libor rose steadily to indicate the higher cost of borrowing.On October 8, 2008, the Fed dropped the fed funds rate to 1.5%. Libor rose to a high of 4.8% on October 13. By the end of the month, the Dow had fallen 14%.By the end of 2009, Libor returned to more normal levels

Since 2010, Libor has steadily declined to be closer to the fed funds rate. From 2010 to 2013, the Fed used quantitative easing to keep Libors rates low.

Ans C)

In 2008 the United States Congress passed—and then-President George W. Bush signed—the Economic Stimulus Act of 2008, a $152 billion stimulus designed to help stave off a recession. The bill primarily consisted of $600 tax rebates to low and middle income Americans.

The United States combined many stimulus measures into the American Recovery and Reinvestment Act of 2009, a $787 billion bill covering a variety of expenditures from rebates on taxes to business investment. $184.9 billion was to be spent in 2009, and $399.4 billion was to be spent in 2010 with the remainder of the bill's appropriations spread over the rest of the decade.Announcements of rescue plans were associated with positive returns whereas a public intervention in favor of a specific bank showed negative impacts.

The U.S. House also gave approval to the $700 billion bailout for the financial system, reversing course to authorize which was the most expensive U.S. government intervention in history.

Ans D)financial contagion refers to a situation whereby instability in a specific market or institution is transmitted to one or several other markets or institutions. There are two ideas underlying this definition. First, the wider spreading of instability would usually not happen without the initial shock. Second, the transmission of the initial instability goes beyond what could be expected from the normal relationships between markets or intermediaries, for example in terms of its speed, strength or scope.

The purtagal sovereign debt ciris is called case of contagion because this debt crisis forced five out 17 Eurozone countries to seek help from other nations. Some believed that negative effects could spread further possibly forcing one or more countries into default.

Ans E)Sovereign default is a failure in the repayment of a county's government debts. Countries are often hesitant to default on their debts, since doing so will make borrowing funds in the future difficult and expensive. However, sovereign countries are not subject to normal bankruptcy laws and have the potential to escape responsibility for debts without legal consequences.