Why is LIBOR so important?
Easiest defaultable rate: the rate at which highly rated
commercial banks can borrow and lend
term interest rate benchmarks
Overnight, 1 Week, 1
Why is it the benchmark? Difficult to manipulate
Vast majority of interest rate derivatives and many bond
issuances are linked to LIBOR
Floating rates on bonds, forwards and swaps
(insert your favorite currency)
shore deposit rates, set by BBA, exist for a number of other
Pound Sterling, Japanese Yen, Swiss Franc, Canadian Dollar, Australian
There are also deposit rates set in other localities: TIBOR
(Tokyo interbank offered rate), etc.
LIBOR is Defaultable
Deposits are not guaranteed by FDIC
If there is a banking crises…
Example: Japanese banking system
LIBOR should always (or almost always) be higher than
Difference between them is the TED spread
Treasury over Eurodollar
Measure of health of banking sector?
Historical Time series
LIBOR and 9/11
How to model defaultable rates?
Model defaultable rates in a manner similar to equities: adjust
If we let r
denote the default
free rate, then the defaultable rate
R is given by: R
s is the spread and is given equal to s
L is the amount of par value lost
h is the probability of default.
The TED spread is one example of a spread, and swap spreads
(next class) are longer
Forward rates as an interest rate risk hedge
LIBOR as a benchmark for defaultable rate
Forward rates allow us to remove interest rate risk over a given
period in the future: m periods ahead for n periods
What if we want to be able to remove such risks on a regular
Solution: swaps (next class)
End of first part
Fixed Income – Lecture 4 (part 2)
Interest rate swaps
An interest rate swap is an agreement between two parties to
exchange period cash flows
One party pays a fixed rate and receives a floating rate
The other party pays floating and receives fixed.
Gives indirect access to fixed or floating capital markets
Allows them to manage their asset/liability structure.
A tool for hedging risk and speculation
You can swap anything (as Enron has showed us).