What Is the LIBOR Curve?
The LIBOR curve is the graphical representation of the interest rate term structure of various maturities of the London Interbank Offered Rate, commonly known as LIBOR. LIBOR is the short-term floating rate at which large banks with high credit ratings lend to each other. The LIBOR curve depicts the yield curve for short-term LIBOR rates of less than one year.
- The LIBOR curve depicts the yield curve for various short-term LIBOR maturities in graphical form.
- These LIBOR rates range from overnight up to several months in matruity.
- The LIBOR curve is looked at to see how lending rates in a variety of debt markets are expected to behave in the near- to mid-term.
Understanding the LIBOR Curve
LIBOR is the world's most widely used benchmark for short-term interest rates. It serves as the primary indicator for the average rate, at which contributing banks may obtain short-term loans in the London interbank market. Currently, there are 11 to 16 contributor banks for five major currencies (U.S. Dollar, Euro, British Pound, Japanese Yen, and Swiss Franc). The LIBOR curve plots rates against their corresponding maturities. The LIBOR curve typically plots its yield curve accross seven different maturities — overnight (spot next (S/N)), one week, and one month, two months, three months, six months, and 12 months.
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve) and flat.
- Upward sloping—long term yields are higher than short term yields. This is considered to be the "normal" slope of the yield curve and signals that the economy is in an expansionary mode.
- Downward sloping—short term yields are higher than long term yields. Dubbed as an "inverted" yield curve and signifies that the economy is in, or about to enter, a recessive period.
- Flat—very little variation between short and long term yields. Signals that the market is unsure about the future direction of the economy.
The LIBOR curve and the Treasury yield curve are the most widely used proxies for the risk-free interest rates. Although not theoretically risk-free, LIBOR is considered a good proxy against which to measure the risk/return tradeoff for other short-term floating rate instruments. The LIBOR curve can be predictive of longer-term interest rates and is especially important in the pricing of interest rate swaps.
Phasing-Out of LIBOR?
Abuse of the LIBOR system for personal gain was uncovered in the wake of the financial crisis that began in 2008. Massive dislocations in global banking enabled individuals working at contributor banks to manipulate LIBOR rates. In 2013, the Financial Conduct Authority (FCA) of the U.K. took over the regulation of LIBOR. Currently, plans are under consideration to phase out the LIBOR system by 2021 and replace it with a benchmark based on U.S. Treasury repo rates or the Sterling Overnight Index Average.