LIBOR, EURIBOR & PRIME rates

By Sabitha Easo
CDO Production
LIBOR, EURIBOR & PRIME rates

Reference Rates

A reference rate is the rate that determines pay-offs in a

financial contract and that is outside the control of the
parties to the contract. It is often some form of LIBOR rate ,
but it can take many forms, such as consumer price index , a
house price index or an unemployment rate. Parties to the
contract choose a reference rate that neither party has the
power to manipulate.

Examples of Use

The most common use of reference rates is that of short

term interest rates such as LIBOR in floating rates notes,
loans, swaps , short term interest rate futures contracts, etc.
The rates are calculated by an independent organisation,
such as the British Bankers Associatiom (BBA) as the
average of the rates quoted by a large panel of banks, to
ensure independence.

Another example is that of swap reference rates for constant

maturity swaps. The rate is used and calculated daily by an
independent organisation, the International Swaps and
Derivatives Association, from quotes from a large panel of
banks.
In the credit derivative market a similar concept to reference
rates is used. Payoffs are not determined by a rate, but by a
possible events. In this case, the reference event has to be a
very precisely defined credit event , to make sure there can
be no disagreement on whether the event has occurred or
not.

Typically the benchmark LIBOR is the three-month rate.

Reference rates for short term interest rates

Examples of reference rates for short term interest rates
are:

♦ LIBOR – London Interbank Offered Rate

♦ EURIBOR – Euro Interbank Offered Rate
♦ SIBOR – Singapore Interbank Offered Rate
♦ TIBOR – Tokyo Interbank Offered Rate
♦ WIBOR – Warsaw Interbank Offered Rate
♦ MIBOR – Mumbai Interbank Offered Rate
♦ KIBOR – Karachi Interbank Offered Rate
 LIBOR(London Interbank
Offered Rate)

What does London Interbank Offered Rate – LIBOR

mean?

An interest rate at which banks can borrow funds, in

marketable size, from other banks in the London interbank
market. The LIBOR is fixed on a daily basis by the British
Bankers' Association. The LIBOR is derived from a filtered
average of the world's most creditworthy banks' interbank
deposit rates for larger loans with maturities between
overnight and one full year.

Investopedia explains London Interbank Offered Rate -

LIBOR as the world's most widely used benchmark for short-
term interest rates. It is important because it is the rate at
which the world's most preferred borrowers are able to
borrow money. It is also the rate upon which rates for
less preferred borrowers are based. For example, a
multinational corporation with a very good credit rating may
be able to borrow money for one year at LIBOR plus four
or five points.
Countries that rely on the LIBOR for a reference rate include
the United States, Canada, Switzerland and the U.K.

The London Interbank Offered Rate (or LIBOR) is a

daily reference rate based on the interest rates at which
banks borrow unsecured funds from other banks in the
London wholesale money market (or interbank market).

Introduction of LIBOR

In 1984 it became apparent that an increasing number of

banks were trading actively in a variety of relatively new
market instruments, notably interest rate swaps, foreign
currency options and forward rate agreements. While
recognizing that such instruments brought more business
and greater depth to the London Interbank market, bankers
worried that future growth could be inhibited unless a
measure of uniformity was introduced. In October 1984
the British Bankers' Association—working with other
parties, such as the Bank of England—established various
working parties, which eventually culminated in the
production of the BBAIRS terms—the BBA Standard for
Interest Rate Swaps. Part of this standard included the
fixing of BBA interest-settlement rates, the predecessor of
BBA LIBOR. From 2 September 1985 the BBAIRS terms
became standard market practice.

BBA LIBOR fixings did not commence officially before 1st

January 1986, although before that some rates were fixed
for a trial period commencing in December 1984.

Member banks are international in scope, with more than

sixty nations represented among its 223 members and 37
associated professional firms (as of 2008).
Scope
LIBOR is an index which is used to set the cost of various
variable rate loans. Lenders use such an index, which varies,
to adjust interest rates as economic conditions change. They
then add a certain number of percentage points called as
margin, which doesn’t vary, to the index to establish the
interest rate you pay. When this index goes up , interest
rates on any loans tied to it also go up. Although it is
increasingly used for consumer loans, it has traditionally
been a reference figure for corporate financial transactions.

Rate calculations are complex as they incorporate variables

such as time, maturity and currency rates. There are
hundreds of LIBOR rates reported each month in numerous
currencies.

We report the SIX MONTH LIBOR on or after the first of the

month. This is the LIBOR for a six month deposit in the U.S.
Dollars on the last business day of the previous month.

LIBOR rates are widely used as a reference rate for financial

instruments such as

♦ forward rate agreements

♦ short-term-interest-rate futures contracts
♦ interest rate swaps
♦ inflation swaps
♦ floating rate notes
♦ syndicated loans
♦ variable rate mortgages
 ♦ currencies , especially the US dollar (see
also Eurodollar).

They thus provide the basis for some of the world's most
liquid and active interest-rate markets.
For the Euro, however, the usual reference rates are
the Euribor rates compiled by the European Banking
Federation, from a larger bank panel.

A Euro LIBOR does exist, but mainly for continuity purposes

in swap contracts dating back to pre-EMU times. LIBOR is an
estimate and not interred in the legally binding contracts of
an LLC. It is however specifically mentioned as a reference
rate in the market standard International Swaps and
Derivatives Association documentation, which are used by
parties wishing to transact in over-the-counter interest rate
derivatives.

LIBOR is used by the Swiss National Bank as their reference

rate for monetary policy.
Technical features
LIBOR is calculated and published by Thomson Reuters on
behalf of the British Bankers' Association (BBA) after 11:00
am (and generally around 11:45 am) each day (London
time).

It is a trimmed average of inter-bank deposit rates offered by

designated contributor banks, for maturities ranging from
overnight to one year. LIBOR is calculated for 10 currencies.
There are either eight, twelve or sixteen contributor banks
on each currency panel and the reported interest is the
mean of the middle values (the interquartile mean). The
rates are a benchmark rather than a tradable rate, the
actual rate at which banks will lend to one another continues
to vary throughout the day.

LIBOR is often used as a rate of reference for Pound

Sterling and other currencies, including US
dollar, Euro, Japanese Yen, Swiss Franc, Canadian
dollar, Australian Dollar, Swedish Krona, Danish
Krone and New Zealand dollar.
In the 1990s, Yen LIBOR rates were influenced by credit
problems affecting some of the contributor banks.
Six-month USD LIBOR is used as an index for some
US mortgages. In the UK, the three-month GBP LIBOR is used
for some mortgages— especially for those with adverse
credit history.

Definition of LIBOR
LIBOR is defined as:
"The rate at which an individual Contributor Panel
bank could borrow funds, were it to do so by asking
for and then accepting inter-bank offers in reasonable
market size, just prior to 11.00 London time."
This definition is amplified as follows:-

♦ The rate at which each bank submits must be formed

from that bank’s perception of its cost of funds in the
interbank market.
♦ Contributions must represent rates formed in London
and not elsewhere.
♦ Contributions must be for the currency concerned, not
the cost of producing one currency by borrowing in
another currency and accessing the required currency
via the foreign exchange markets.
 ♦ The rates must be submitted by members of staff at a
bank with primary responsibility for management of a
bank’s cash, rather than a bank’s derivative book.
♦ The definition of “funds” is: unsecured interbank cash
or cash raised through primary issuance of interbank
Certificates of Deposit.

LIBOR-based derivatives

Eurodollar contracts
The Chicago Mercantile Exchange's Eurodollar contracts are
based on three-month US dollar LIBOR rates. They are the
world's most heavily traded short term interest rate futures
contracts and extend up to ten years. Shorter maturities
trade on the Singapore Exchange in Asian time.

LIBOR-based derivatives
Interest rate swaps
Interest rate swaps based on short LIBOR rates currently
trade on the interbank market for maturities up to 50 years.
A "five year LIBOR" rate refers to the 5 year swap rate v/s 3
or 6 month LIBOR. "LIBOR + x basis points", when talking
about a bond, means that the bond's cash flows have to be
discounted on the swaps' zero-coupon yield curve shifted
by x basis points in order to equal the bond's actual market
price. The day count convention for LIBOR rates in interest
rate swaps is Actual/360.
Reliability
On Thursday, 29 May 2008 the Wall Street
Journal released a controversial study suggesting that banks
may have understated borrowing costs they reported for
LIBOR during the 2008 credit crunch. Such underreporting
could have created an impression that banks could borrow
from other banks more cheaply than they could in reality. It
could also have made the banking system or specific
contributing bank appear healthier than it was during the
2008 credit crunch.

For example, the study found that rates at which one major
bank "said it could borrow dollars for three months were
about 0.87 percentage point lower than the rate calculated
using default-insurance data."

In response to the study released by the WSJ, the British

Bankers' Association announced that LIBOR continues to
be reliable even in times of financial crisis. According to the
British Bankers' Association, other proxies for financial
health, such as the default-credit-insurance market, are not
necessarily more sound than LIBOR at times of financial
crisis, though they are more widely used in Latin America,
especially the Ecuadorian and Bolivian markets.

Additionally, other authorities have contradicted the Wall

Street Journal article. In their March 2008 Quarterly
Review The Bank for International Settlements have stated
that "available data do not support the hypothesis that
contributor banks manipulated their quotes to profit from
positions based on fixings". Further, In October 2008
the International Monetary Fund published their
regular Global Financial Stability Review which also found
that "Although the integrity of the U.S. dollar LIBOR-fixing
process has been questioned by some market participants
and the financial press, it appears that U.S. dollar LIBOR
remains an accurate measure of a typical creditworthy
bank’s marginal cost of unsecured U.S. dollar term funding"

EURIBOR(Euro Interbank
Offered Rate)

The Euro Interbank Offered Rate (EURIBOR) is a daily

reference rate based on the averaged interest rates at which
banks offer to lend unsecured funds to other banks in the
euro wholesale money market (or interbank market).

Scope

Euribors are used as a reference rate for euro-denominated

forward rate agreements, short term interest rate futures
contracts and interest rate swaps , very much the same way
as LIBORs are commonly used for Sterling and US dollar
denominated instruments. They thus provide the basis for
some of the world’s most liquid and active interest rate
markets.
Domestic reference rates, like Paris’ PIBOR, Frankfurt’s
FIBOR, and Helsinki’s HELIBOR merged into EURIBOR on EMU
day on 1 January 1999.

Technical Features

A representative panel of banks provide daily quotes of the

rate, rounded to two decimal places, that each panel bank
believes one prime bank is quoting to another rime bank for
interbank term deposits within the Euro zone, for maturity
ranging from one week to one year. Every panel bank is
required to directly input its data no later than 10.45 a.m.
(CET) on each day that the Trans European Automated Real
Time Gross-Settlement Express Transfer System is open.
At 11.00 a.m. (CET), Reuters will process the Euribor
calculation and instantaneously publish the reference rate on
Reuters pages 248-249, which will be made available to all
its subscribers an to other data vendors.
The published rate is rounded, truncated mean of the quoted
rates: the highest and the lowest 15% of the quotes are
eliminated, the remainder are averaged and the result is
rounded to 3 decimal places.
Euribor rates are spot rates i.e. for a start two working days
after measurement day. Like US money-market rates, they
are Actual/360, i.e. calculated with an exact daycount over a
360-day year.
Euribor was first published on 30 December 1998 for value 4
January 1999.
Interest rate Swaps

Interest rate swaps based on short Euribors currently trade

on the interbank market for maturities up to 50 years. A
“five year Euribor” will be in fact referring to the 5 year swap
rate v/s 6 month Euribor. “Euribor + x basis points”, when
talking about a bond, will mean that the bond’s cash flows
have to be discounted on the swaps’ zero coupon yield curve
shifted by x basis points in order to equal the bond’s actual
market price.

PRIME RATE

Prime rate or prime lending rate is a term applied in many

countries to a reference interest rate used by banks. The
term originally indicated the rate of interest at which banks
lent to favoured customers, i.e., those with high credibility,
though this is no longer always the case. Some variable
interest rates may be expressed as a percentage above or
below prime rate.

Use in banking systems

United States and Canada
Historically, in North American Banking, the prime rate was
the actual interest rate although this is no longer the case.
The prime rate varies little among banks, and adjustments
are generally made by banks at the same time, although this
does not happen with frequency. The prime rate is currently
3.25% in the United States. Canadian prime rate is currently
2.75%.
In the US, the prime rate runs approximately 300 basis
points ( or 3 percentage points) above the federal funds rate,
the interest rates that banks charge to each other for
overnight loans made to fulfill reserve funding requirements:
(federal funds rate) + (3%) = (prime rate). The Federal funds
rate plus much smaller increment is frequently used for
lending to the most creditworthy borrowers today, as is
LIBOR, the London Interbank Offered Rate. The Federal Open
Market Committee (FOMC) meets eight times per year
wherein they set a target for the federal funds rate. Other
rates, including the prime rate, derive from this base rate.

Prior to December 17, 2008, when 23 out 30 of the United

States’ largest banks changed their prime rate, the Wall
Street Journal would change its published rate. On
December 17, 2008, the Wall Street Journal recognized
that fewer but larger banks controlled most assets and
changed the methodology for the prime rate that is
published. The Journal’s rate today now reflects the base
rate posted by at least 70% of the top ten banks by assets.
Since December 17, 2008 the WSJ’S U.S. Prime Rate has
been 3.25%.

Uses
The prime rate is used often as an index in calculating rate
changes to adjustable rate mortgages (ARM) and other
variable rate short term loans. It is used in the calculations
of some private student loans. Many credit cars and home
equity lines of credit with variable interest rates have their
rate specified as the prime rate (index) plus a fixed value
commonly called the spread or margin.