What is the LIBOR?

We have all seen the London Interbank Offered Rate (LIBOR) cited in several articles and news items. What is the LIBOR and how does it affect currency markets including the Interbank Forex? Simply put, the LIBOR is a daily reference rate based on the interest rates at which banks are willing to lend unsecured funds to each other in the London money market.

LIBOR Published Daily

The LIBOR is published by the British Bankers Association and is released daily, usually at 11:45 AM (London Time). It is basically an average of interest rates charged by banks for loans ranging from overnight to one year. There are 16 contributing banks and the reported interest is the mean of the eight middle banks. The rates for shorter loans are considered to be reliable and reflect the rates at which banks are willing to lend to each other. The actual rate can vary several times a day affecting Interbank Forex markets.

LIBOR Used as Currency Reference

The LIBOR is used as a reference for the British Pound and other currencies including the US dollar, Euro, Japanese Yen, Swiss Franc, Canadian dollar, Australian Dollar, Danish Krone and New Zealand dollar. The LIBOR is closely watched by Forex traders and investors and has a profound effect on the Interbank Forex market.

When the LIBOR rises it indicates two things, 1. That interest rates in general are rising and thus LIBOR is also rising, and 2. Lending banks believe the banks they are lending to have a higher risk of defaulting on the loan so the lending bank has to charge a higher interest rate to offset this risk.

When the LIBOR is falling it indicates that 1. Interest rates are falling and thus LIBOR is falling, and 2. Lending banks believe the banks they are lending to have a lower risk of defaulting so the bank does not have to charge higher interest rates to mitigate the risk.

LIBOR and Interbank Forex

The interbank Forex market is strongly affected by the LIBOR reports. The LIBOR signifies several rates that are calculated in 10 different currencies and is set every business day. The LIBOR rate is calculated daily for these currencies,

1. Pound Sterling (GBP)
2. United States Dollar (USD)
3. Japanese Yen (JPY)
4. Swiss Franc (CHF)
5. Canadian Dollar (CAD)
6. Australian Dollar (AUD)
7. Euro (EUR)
8. Danish Kroner (DKK)
9. Swedish Krona (SEK)
10. New Zealand Dollar (NZD)

The LIBOR for a specific currency depends on the local interest rate for the currency, such as the Fed rate for the UDS, and banks’ expectation of future rates. The LIBOR is important to markets including the Interbank Forex for a variety of reasons; it is long established, it is a truly international reference rate, it has a wide commercial use, it offers the largest range of international rates, and its mechanism is transparent. The banks providing the data for the LIBOR are the most active in cash markets and have the highest standards and credit ratings.

LIBOR Has Major Influence on Forex Markets

Unfortunately individual investors do not have access to LIBOR data and to receive LIBOR reports must be licensed by the British Bankers Association. The LIBOR is easily one of the most important reports watched by Forex traders and has a major influence in Interbank Forex markets globally.

LIBOR and Loans

Many are unaware of the LIBOR (London Interbank Offered Rate) and how it affects them in their daily lives. The LIBOR is the average interest rate that banks charge when they make short-term unsecured loans to other banks. This, in turn, affects interest rates for such things as student loans, mortgages, and the value of major currencies and is a major influence on the Interbank Forex market. It is essentially the interest rates of 16 major banks averaged out. Approximately 80% of all sub prime mortgages are tied to the LIBOR.

Mortgages Tied to LIBOR Rate

If a mortgage is obtained chances are that the interest rate is closely tied to the LIBOR or other indexes such as the Cost of Funds Index (COFI). Loans are typically pegged to indexes called the one-month, three-month or six-month LIBOR. The rates reflect the averages of what banks are charging for longer term loans and those with adjustable rate mortgages can be in for a very unpleasant shock if rates rise. It is estimated that 60% of all adjustable loans in the US are tied to the LIBOR. Unfortunately most buyers have no idea what the LIBOR is and how it can affect their lives.

LIBOR and Short Term Corporate Loans

The LIBOR is also the benchmark for short term corporate loans. If the LIBOR goes up it impacts a wide range of borrowers including corporations and small businesses that depend on the availability of credit to finance day to day operations. If credit markets freeze or interest rates rise it can directly affect businesses resulting in layoffs and rising prices for consumer goods. The LIBOR also affects the value of various currencies on Interbank Forex markets.

LIBOR Rate and Student Loans

Almost 50% of all lenders peg the interest rate charged to the LIBOR and student loans are no exception. Rates tied to the LIBOR are typically LIBOR+2.80%. If rates go up the loan becomes more expensive and can significantly increase the cost of a college education. The recent credit crunch has adversely affected the availability of student loans. Many economists are telling those with loans tied to the LIBOR to brace themselves for a rise in interest rates.

LIBOR and Interbank Forex

LIBOR has a profound influence in currency markets including the Interbank Forex. The spread between 90 day T-bill and 90-day LIBOR rates can give investors a sense of confidence in the US dollar. When confidence in the US dollar is high the spread will be very close while conversely, if confidence is low the spread will be higher. While LIBOR is primarily about interbank lending rates it can reflect investor confidence in various currencies on the Interbank Forex market.

LIBOR Affects Confidence in the Dollar

If you have a mortgage, have taken out a student loan, or work for a company that depends on the availability of credit, the LIBOR can have an impact on your financial life. The LIBOR helps to determine the confidence that Interbank Forex investors have in the Dollar and helps to determine the exchange rate. Although located in far away London the LIBOR has a direct impact on the daily lives of Americans.

Investors Continue to Buy Dollars

Despite the global economic crisis the US dollar has remained surprisingly strong on currency markets including the interbank Forex. Many Forex traders and investors have continued to buy dollars to avoid risk. The dollar remains the world’s reserve currency and continues to outperform the Euro and the Pound.

Dismal US Employment Figures

All that could change because of recent figures released showing a loss of 240,000 non farm jobs, the largest loss in seven years. The US labor market continues to deteriorate and in the last three months the US has lost 651,000 jobs. This recent information sent shock waves through currency markets including the Interbank Forex. Michael Woolfolk, senior currency strategist at Bank of New York Mellon stated; “The report shows the labor market continued to deteriorate at the start of the fourth quarter and we have to keep in mind that it doesn’t yet reflect much of the job losses on Wall Street.”

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Low Oil Prices Inspire Confidence

New York stock markets showed positive gains as the lowest oil prices in more than a year inspired investor confidence. The Dow rose 240 points having been down as much as 380 points in the late morning. Stocks were down in morning trading as investors responded to a pair of weak manufacturing reports, Merrill Lynch and Citigroup’s losses and the decline in oil prices. Oil prices continued to decline after the government’s weekly inventory report showed a larger than expected gain in crude and gas supplies. Perceptions of slowing demand have sent oil prices lower than the all time high of July, 11^th.

Fear of Recession Looms

The decline is seen by many as another indication of a global economic slowdown. Despite recent good news there is still a fear of a global recession with some saying the US has already entered a recession. Many analysts say that market volatility is here to stay. Said Gary Flam, portfolio manager, Bel Air Investment Advisors, “To a certain extent, we’re in the middle of a hurricane, “It will pass eventually and we will get through it, but there’s been a lot of damage.” Credit markets remain frozen affecting interbank Forex markets.

Factory Production Lowest in 34 Years

While investors have welcomed recent government actions the negative tone of markets reflect the fact that the effect of many programs will take months to be felt. Recession fears sent stocks plunging Wednesday with the Dow falling 733 points making the session the second worst ever on a point basis. Adding to the bad news the Federal Reserve announced that factory production fell by the largest amount in nearly 34 years. The fall was blamed on the effect of hurricanes Ike and Gustav had on Gulf coast industry. The Philadelphia Fed index, a regional reading on manufacturing fell to an 18 year low. The Index had an original prediction of a decline of negative 5 while the actual figure was a whopping negative 37.5 far exceeding the original forecast. Despite the negative economic indicators the US dollar is still holding it’s own on interbank Forex markets.

TED Spread Hits Record

Lending rates improved slightly with the overnight lending rate falling to 1.94% down from 2.14% late Wednesday. The 3 month LIBOR fell to 4.50% down from 4.55%. The TED spread which is the difference between what banks pay to borrow from each other for three months and what the Treasury pays narrowed to 4.11% from 4.31%. The spread hit a record 4.65% Friday and the wider the spread the more reluctant banks are to lend to each other. This is certainly not good news for credit markets or interbank Forex markets.

Interbank Forex and Lending

Although the performance of markets this week has been hopeful the long term does not look positive. Negative economic indicators and recession fears are looming in the background and psychology plays a big part in market performance. The positive effects of many bailout programs will take months to be felt and investors are sure to be in for a wild ride. Interbank Forex lending is important for Forex traders and markets. Fortunately for Forex investors’ currency does not fluctuate as wildly as stocks and securities and many Forex investors have made impressive gains despite the global economic crisis.

European Lending Rates Jump

Key bank to bank long term lending rates in Europe jumped to their highest since 1995 from 5.142 to 5.237 a move sure to reverberate through Interbank Forex markets. The six month rate also jumped to 5.315 from a former rate of 5.290. European rates are fixed by the European Central Bank. (Euribor) It is becoming painfully obvious that the financial crisis is not limited to the US.

The Contagion Spreads

The US financial crisis has become contagious, spreading to European banks and financial institutions and Interbank Forex markets worldwide. In the UK mortgage giant Bradford and Bingley had to be rescued by the government. Shares of French bank Dexia tumbled more than 20% because of a newspaper report that the bank may launch an emergency capital increase. On Sunday the governments of Belgium, Luxembourg, and the Netherlands announced an 11.2 Euro bailout of one of Europe’s largest banks.

Highlights of the US Bailout Plan

Markets, including the Interbank Forex, have been in a state of disarray with global money markets waiting for the details of the proposed US bailout. The US congress is set to vote on the compromise bailout package on Monday, September 29^th. After almost a week of political haggling Democrats and Republicans have reached an agreement. Highlights of the bailout plan include;

• The government would have broad powers to buy billions in mortgage related assets.

• The plan lets congress block half the money. The government can access 250 billion immediately, 100 billion more if the president certified it was necessary, and 350 billion more with a separate certification.

• Executives of companies who benefit from the bailout will see limited compensation.

• The plan requires the government to try to renegotiate bad mortgages with the intention of lowering monthly payments.

• The government would receive stock warrants in return for assistance, giving American taxpayers the opportunity to share in future profits.

• After five years the government would submit a plan to congress on how to recover any losses from companies receiving assistance.

Financial analysts are hoping that the passage of the US bailout plan will bring a semblance of stability to global markets. With the crisis spreading well beyond the borders of the United States passage of the compromise bailout plan is seen by many as a way to stem the tide of bank failures in Europe. Credit markets and interbank forex lending have all been virtually frozen by the US financial crisis and it is hoped that the infusion of billions of dollars will cause credit to flow freely again. It is hoped that the bailout and other recent actions of the Fed will shore up the US dollar on both retail and interbank Forex markets.

A Brief History of AIG

American International Group, Inc. was founded in 1919 in Shanghai, China by Cornelius Vander Starr. Mr. Starr was the first westerner in Shanghai to sell insurance to the Chinese. The firm was successful and expanded it’s operations to other countries in Europe, Latin America, and the Middle East. In 1962 AIG gave control of the unsuccessful US operations to Maurice Greenberg who changed the company’s focus from personal insurance to high margin corporate coverage.

A Shady Past

By 2005 AIG was the subject of a number of fraud investigations by the US Justice Department, the Securities and Exchange Commission, and the New York Attorney General’s office. The investigations resulted in the ousting of Mr. Greenberg, a $1.6 billion dollar fine, and several executives faced criminal charges. After several CEO’s were forced to step down Edward M. Liddy became CEO on September 17, 2008.

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The Forex Market

The forex market is one of the largest, if not the largest market with up to two trillion dollars traded daily. Unlike stock exchanges the interbank forex market is not a centralized market. In a centralized market like the stock exchange there is a central every transaction is recorded by price and volume.

The forex market is a decentralized market with no central market where transactions are recorded. The interbank forex market relies on market makers who record their own transactions and the information is kept private. A market maker is a broker-dealer firm that facilitates the buying and selling of securities or currency. The primary market makers in forex are the world’s largest banks.

The Interbank Forex Market

The interbank market is the system of trading currencies among the world’s largest banks and while most of the transactions are done between the banks themselves some banks do handle forex transactions on behalf of large customers. It has been estimated that 50% of all interbank forex transactions are between the banks themselves. The interbank forex is the source of price quotes that enable investors and brokers to make informed decisions.

Interbank Forex Transactions

According to the Wall Street Journal 73% of all interbank forex transactions are done through 10 major banks. Most of these banks maintain a separate group known as the Foreign Exchange Sales and Trading Department. Each Foreign Exchange department contains a sales and trading desk. The sales desk is responsible for taking orders from clients, getting market quotes and relaying that information to the client. The Trading Desk is responsible for making decisions based on market information and many traders specialize in certain currency pairs. Usually banks will have traders that are responsible for all trading in specific currency pairs, the EURO/USD for example.

Banks determine currency prices by a variety of factors; how much of a particular currency is available at the current price, the current market rate, inventory, and opinions on where the price of the currency is headed. Unfortunately banks are reluctant to share all this information with brokers and investors.

Interbank Forex and the Small Investor

In the past the interbank forex market was the exclusive domain of the world’s major banks and small investors were excluded. Today firms are able to offer access to this dynamic market to individual investors. The interbank forex market is available 24 hours a day and quotes may be seen online for easy monitoring of accounts. The interbank forex market is no longer the province of banks alone. The interbank forex market is available 24 hours a day, six days a week so individual investors are not limited to traditional business hours. The interbank forex market offers some very exciting opportunities to investors, large or small.