About half a century ago most loans were on a fixed interest rate basis. That is, the prescribed interest rate would remain constant for the maturity of the loan. For instance, if one had taken a housing loan about 50 years ago, the interest rate would have remained constant for 15-20 years. The growth of the Eurocurrency market lead to the design of loans with floating rates of interest. A Eurocurrency is a freely traded currency deposited in a country outside the home country of the currency. For instance, dollars deposited outside the US are Eurodollars, while yen deposited outside Japan are Euroyen. The rupee is not a freely traded currency. Else a rupee deposited in Dubai or Singapore would constitute a Eurorupee. In a floating rate loan the interest rate is pegged to a benchmark. Higher the benchmark the higher the rate of interest, whereas the lower the bench market the lower will be the rate of interest. The most common benchmark is the London Interbank Offer Rate or LIBOR. This is the rate at which a bank in London is willing to lend or make a loan. Banks are after all dealers. Consequently they have a bid-ask spread, which is the difference between the lending and borrowing rates. The bid-ask spread for a bank is termed as the Net Interest Margin. If a party were to call a bank in London, he would get two rates.
Libor and Mibor
One at which the bank is willing to borrow called LIBID, and the other at which it is prepared to lend called LIBOR. Obviously the LIBID will be lower than the LIBOR. From the standpoint of adopting a benchmark both LIBOR and LIBID are suitable, although LIBOR is the more common choice. Sometimes the two are averaged to get a rate termed as LIMEAN, which too can be a benchmark. Similar to LIBOR there are other benchmarks based on different cities. New York has a NIBOR whereas Tokyo has a TIBOR. Mumbai has a rate called the MIBOR. If one were to call banks in London, there would be a difference, albeit small, between the rates quoted by different banks. So the issue is how does one determine a benchmark? In the case of LIBOR the benchmark is ICE LIBOR produced by the Intercontinental Exchange. To compute the LIBOR, ICE polls members of a panel of contributor banks. Once the quotes are obtained, they are ranked in descending order. The top 25% and the bottom 25% are excluded because they may constitute extreme values. The remaining observations are averaged. This procedure is termed as computing a trimmed arithmetic mean. The Eurodollar futures contract is based on the LIBOR. The Euroyen futures contract is based on both the LIBOR as well as the TIBOR. Interest rate swap contracts, both fixed-floating (coupon swaps), and floating-floating (basis swaps), usually have LIBOR as a benchmark. Forward rate agreements, which are forward contracts on an interest rate, also usually have LIBOR as the prescribed benchmark. While LIBOR is by far the most widely used benchmark, for currencies other than the US dollar there are alternatives. For instance Euro based transactions often use the EURIBOR, which is produced by the European Money Markets Institute.
Sunil K Parameswaran
The author is visiting faculty at various business schools including IIMs