DEFINITION of Interest Rate Index
An interest rate index is an index based on the interest rate of a financial instrument or basket of financial instruments. An interest rate index serves as a benchmark to calculate the interest rate that lenders may charge on financial products such as mortgages.
BREAKING DOWN Interest Rate Index
Investors, borrowers and lenders will use an interest rate index to determine the interest rates of the financial products they buy and sell.
An interest rate index can be based on changes to a single item, such as the yield on U.S. Treasury securities, or on a more complex series of rates. For example, an index may be based on the monthly weighted average cost of funds for banks within a state.
Many widely used financial products follow an interest rate index. An adjustable rate mortgage (ARM), for example, ties its interest rate to an underlying index. Well-known indexes include the London Interbank Offered Rate (LIBOR) and the Treasury Constant Maturities index.
The LIBOR Interest Rate Index
LIBOR (also known as ICE LIBOR) is the world’s most widely-used benchmark for short-term interest rates. LIBOR serves as the primary indicator for the average rate that contributing banks may obtain short-term loans in the London interbank market. Notably, between 11 and 18 contributor banks currently participate for five major currencies (USD, EUR, GBP, JPY, CHF). LIBOR sets rates for seven different maturities, posting a total of 35 rates every business day.
ICE LIBOR was previously known as BBA LIBOR until Feb. 1, 2014, the date on which the ICE Benchmark Administration (IBA) took over the Administration of LIBOR. It became clear that more than a dozen major banks were misusing their influence over the LIBOR. In June 2012, the Financial Services Authority (FSA) fined Barclays Bank £59.5 million for LIBOR-related failings (specificaly, being out of accordance with the Financial Services and Markets Act 2000). Barclays agreed to an early settlement, and the fine of £85 million worked out to be £59.5 million after a 30 percent discount. U.S. authorities also fined Barclays $360 million for tampering and false reporting of the EURIBOR and LIBOR from 2005 to 2009.
The Treasury Constant Maturities Index
Many lenders use constant maturity yields to determine mortgage rates. The One-Year Constant Maturity Treasury Index is widely used as a reference point for adjustable-rate mortgages (ARMs). Many corporations and institutions also use constant maturity yields as a reference for pricing issuances of debt securities.