What is LIBOR?
The London Interbank Offered Rate, or LIBOR, is the European version of the federalfunds rate in the United States and represents the interest rate at which London banks charge each other on funds borrowed. This is not to be confused with the BBA LIBOR rate, which is a filtered average of inter-bank loans maturing within 1 year. BBA LIBOR is published once per day by the British Bankers Association at around 11 AM London standard time. The BBA is advised by a group of senior banking experts from at least 8 contributor banks and uses their lending activity to derive the BBA LIBOR rate.
How is it used?
LIBOR represents a benchmark for short term borrowing worldwide and is used to settle interest rate contracts in many of the world's futures and options exchanges. BBA LIBOR is created in ten different currencies and is done so by polling a new set of relevant contributor banks for each currency. BBA currency LIBOR will then provide the borrower with an interest rate to borrow a specific currency in the London cash market. You may hear the term Eurodollars or Euroyen; this defines the interest rate at which you can borrow US dollars or Japanese Yen in the London market.
BBA LIBOR is also referenced in many instruments that have a variable rate structure; such as, adjustable rate mortgages, floating rate notes, interest rate swaps, syndicated loans, and much more.
How do you calculate Interest using LIBOR?
BBA LIBOR is not a compounded rate; rather, it is calculated on the basis of the actual funding term. The formula to calculate interest using LIBOR would be done as follows:
Principal Loan Amt X BBA LIBOR rate X (Loan Term/360)
This formula would apply to the US LIBOR ; however, the GBP LIBOR is based on an ACTUAL/365 scheme and therefore you would have to adjust that formula to divide by 365.
How Do Banks Set Equilibrium Forward Rates?
Equilibrium in forward contracts occurs when the forward exchange rate of the two currencies in the contract yield equal returns. Banks calculate their equilibrium forward rates by using the current spot rate, the interest rate of the foreign currency and the interest rate of their domestic currency. Banks base their equilibrium forward rate calculations on the economic theory of interest rate parity
Interest Rate Parity Theory
o The interest rate parity theory is the economic theory in which the interest rate difference between two currencies is equal to the difference between the forward and spot rates of each country's respective currency. When the interest rate parity theory is violated, it disrupts equilibrium and creates arbitrage opportunities for investors. An investor takes advantage of an arbitrage opportunity when he buys and sells the same or similar financial instrument at the same time but in different markets. The investor makes a profit from exploiting the price differences that occurred due to the interest rate parity violation.
Equilibrium Forward Rate Formula Definitions
o The forward exchange equilibrium equals the spot rate multiplied by (1 plus the domestic interest rate) divided by (1 plus the foreign interest rate). The spot rate is the immediate exchange rate between two currencies. The interest rates used in equilibrium forward rate calculations are typically based on the London Interbank Offer Rate (LIBOR). The LIBOR rate is the interest rate banks offer other banks in London's wholesale money markets.
Equilibrium Forward Rate Formula
o To illustrate the formula, say you want to make an investment in euros (EUR). Assume that the current spot rate for EUR to United States dollar (USD) is 1.859, written as euro/USD=1.859. The one-year LIBOR interest rate is 8 percent for euro and 6 percent for USD. The equilibrium forward rate formula for this example is as follows: Forward rate=1.859*[(1+.06)/(1+.08)]. Banks have to break the formula down to: Forward rate=1.859*(1.06/1.08). This breaks down further: Forward rate=1.859*.981. This then equals 1.824.
Discounts and Premiums
o Using that example, to obtain equilibrium, the euro would trade at a discount to the USD. Selling at a forward discount equalizes the higher LIBOR interest of the EUR against the USD and helps to prevent arbitrage. If the situation was reversed and the LIBOR for the USD was higher than the EUR, the EUR would trade a forward premium to equalize the higher LIBOR interest rate of the USD against the EUR.
Read more: How Do Banks Set Equilibrium Forward Rates? | eHow.com http://www.ehow.com/info_8789113_do-set-equilibrium-forward-rates.html#ixzz1Y326s7tg
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