LIBOR (London Interbank Offered Rate) was once one of the most important benchmark interest rates in global finance. It represented the average interest rate at which major banks around the world lent unsecured funds to each other on the London interbank market. Although LIBOR has been largely phased out and replaced by alternative reference rates, understanding its role remains crucial for traders, investors, and financial professionals.

LIBOR was calculated daily for several different currencies (such as USD, GBP, EUR, JPY, and CHF) and for various loan maturities ranging from overnight to one year. The process involved polling a panel of major banks, asking them the rate at which they believed they could borrow funds from other banks. The highest and lowest submissions were discarded, and the remaining rates were averaged to produce the daily LIBOR figure. This rate was widely used as a benchmark for setting interest rates on various financial products, including mortgages, corporate loans, derivatives, and bonds.

Formula: LIBOR = Average of trimmed submissions from panel banks

For example, in the USD 3-month LIBOR calculation, if 18 banks were polled, the top four and bottom four rates would be excluded, and the average of the middle 10 would become the published LIBOR rate for that tenor.

LIBOR’s importance in trading was significant because it was often used as a reference rate for pricing derivatives such as interest rate swaps, futures contracts, and options. For instance, a trader dealing in FX forward contracts might use the LIBOR rates of the currencies involved to calculate the forward points or interest rate differentials.

A real-life example is an FX trader calculating the forward exchange rate between USD and EUR. If the USD 3-month LIBOR is 1.5% and the EUR 3-month LIBOR is 0.5%, the trader would use the interest rate differential to determine the forward premium or discount for that period, impacting the pricing of the forward FX contract.

However, several misconceptions surround LIBOR. One common misunderstanding is that LIBOR was a purely market-driven rate, reflecting actual transaction prices. In reality, LIBOR was based on banks’ self-reported estimates rather than strictly observed borrowing costs. This subjective element led to manipulation scandals, where some banks submitted artificially low or high rates to benefit their trading positions or appear more creditworthy during the 2008 financial crisis.

Another common confusion is between LIBOR and central bank rates like the Federal Funds Rate or the Bank of England base rate. While central bank rates are policy tools set by monetary authorities, LIBOR was a market-based benchmark reflecting interbank lending conditions, and as such, it was often higher than central bank rates due to credit risk and liquidity premiums.

Since LIBOR’s reliability was compromised, regulators initiated a global transition to alternative reference rates that are more transparent and based on actual transaction data. For USD LIBOR, the Secured Overnight Financing Rate (SOFR) has become the preferred replacement. Similarly, SONIA (Sterling Overnight Index Average) replaced GBP LIBOR, and €STR (Euro Short-Term Rate) replaced EUR LIBOR.

Traders and investors must now be aware of the differences between LIBOR and these new rates. For example, SOFR is a nearly risk-free overnight rate based on repo transactions secured by U.S. Treasury securities, whereas LIBOR included a credit risk component and was available for multiple tenors. This difference affects how derivatives contracts and loans are priced and hedged.

Common questions related to LIBOR include: What has replaced LIBOR? How does SOFR differ from LIBOR? Why was LIBOR discontinued? How does LIBOR impact FX forwards and swaps? Understanding these points helps avoid mistakes such as assuming the new rates behave identically to LIBOR or neglecting the impact of rate transitions on existing contracts.

In summary, while LIBOR is no longer actively published as of 2023, it remains a foundational concept in understanding the evolution of benchmark interest rates and their role in trading and financial markets. Its legacy influences how traders price instruments, manage interest rate risk, and adapt to regulatory changes in the financial landscape.