The Basics of LIBOR: the London Interbank Offered Rate

LIBOR potentially affects everyone. Here's how it works

LIBOR
LIBOR is one of the most important interest rates in the world. It has widespread ramifications for asset prices and the cost of capital for nearly everyone in Western civilization. Allan Baxter / Photolibrary / Getty Images

The London Interbank Offered Rate, or LIBOR, is the interest rate that the most credit-worthy banks around the world charge each other for what are considered short-term loans (loans for terms of 24 hours up to five years). The LIBOR is the most famous barometer for short-term interest rates in the world.

This global inter-bank market provides a means for financial institutions with excess capital (in other words, extra money on hand) to earn higher rates of return by loaning liquid assets (the extra money on hand) to those in need of the funds.

Even though you might think an interest rate calculated in London wouldn't affect U.S. interest rates much, many adjustable-rate mortgages and other loans issued in the United States are based on LIBOR. In fact, LIBOR is one of the two most commonly used benchmarks for short-term interest rates worldwide. The other critical benchmark is the Euro Interbank Offered Rate, which is based on the rates used by the leading European banks to borrow money from one another.

LIBOR is released each day at 11 a.m. London time. It then fluctuates throughout the day based upon the market’s expectations for economic activity and the future direction of interest rates.

LIBOR and Eurodollars

LIBOR loans are expressed in Eurodollars. Therefore, to understand how LIBOR is used, you need to understand the purpose of Eurodollars, too.

In short, Eurodollars are U.S. currency held by foreign entities, such as a British or German bank or insurance company.

These entities hold the money outside the U.S., and the money isn't subject to U.S. banking laws.

Eurodollars are most often the result of American companies using U.S. dollars to pay internationally-domiciled corporations for goods, service, and merchandise purchased. According to the Federal Reserve, Eurodollars represent one of the largest short-term money markets in the world.

When the U.S. is running a trade deficit — that is, purchasing more goods from abroad than it sells — the natural result is an increase in Eurodollars since more people from outside the U.S. are purchasing American companies and assets.

Why Is LIBOR So Important?

LIBOR is important because it is often used as the base for variable-rate government and corporate loans and derivative-based products such as credit swaps. This affects everyone from individuals in the U.S. who are shopping for adjustable-rate mortgages to entire countries seeking loans to provide services and build infrastructure.

A small, impoverished nation, for example, may have to pay a spread of a percentage point or two above and beyond the established LIBOR rate to get a loan. Therefore, an increase or decrease in LIBOR will result in a corresponding rise or fall in that nation's cost of borrowing.