What’s LIBOR and for what is used

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What’s LIBOR and for what is used

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What is LIBOR? The base interest rate banks use to lend to each other. Essentially its the interest rate on a loan assuming absolutely zero risk.

What is it used for? ALL loans use this rate as the base rate. You can see loans offered at LIBOR + 2%. This 2% is the “risk” that the loan giver is suffering by not lending the money to a risk free institution such as a bank.

Yes banks aren’t actually risk free but they pretend they are for this to work.

London interbank offered rate,
Intercontinental Exchange (who administer it) ask various banks each day the rate they would lend money of various currencies for various terms, then take the averages, then publish it.

So you end up with overnight libor, 7 day libor etc etc for GBP, USD, EUR etc etc.

It’s being phased out soon to be replaced by an overnight risk free rate, in the UK this is Sonia (sterling overnight indexed average, administered by bank of England), where it effectively moves from “what would you offer?” to “what did you give?”

Sonia/libor are the reference rates for various types of floating rate financial instruments.

Eg, you buy things like bonds that paid libor + a bit of extra margin each month (or nowadays, Sonia plus margin)

How the interest rate is now calculated from the reference rate is different, with libor it was just: rateset today, payment in 3 months, so you took 3 month libor, add your margin. Bosh.

Sonia is published everyday for yesterday, so you build a compounded average for it over the calculation period (realised rate). NatWest markets has a decent explanation on a webpage if you Google.