I am just starting on Interest Rate Swaps & curve construction. While reading few materials on Interest Rate Swap, it's indicated for e.g. "Floating Coupon Index: 6 month USD LIBOR".
LIBOR is the London Inter Bank Overnight Rate. How does it matter for USD? If a security is USD denominated, shouldn't it be valued using some USD based interest rate e.g. Treasury security rates? Why does USD based security valuation have to give a thing about what London Banks think? US still remains the largest bond market in the world...though. Even following link states USD LIBOR is what London banks prepared to lend $$$.00...
It doesn't seem to stop there, as couple of other currencies have their LIBORs available as well. Why there has to be a USD LIBOR in the first place?
- Reference:
Answer
The importance here is that it actually does not matter in what time zone or market the libor rates are set. Key is that it is supposed (!!!) to be a gauge at what rate contributing banks could borrow funds at in the inter-bank market. Like you can go to any African country and borrow or lend US dollar, so can any Japanese, European, or American bank borrow and lend US dollar in either New York, London, or any other money center. London was chosen out of convenience because it has traditionally been accepted as a convenient time zone (vs Japan or the US) for international trade, such as currency exchange and for many international fixed income asset classes.
The importance of Lie-bor has been greatly diminished due to the following, however:
- Due to the most recent rate setting scandal
- Because of the changes in dynamics in the money and rates market (a. increased market focus on IOER and RRP rates rather than fed fund target rate,and b. the Fed will possibly change its policy rate to RRP)
- Because the current low spread of libor over top-tier CP begs a lot of questions as to whether libor adequately reflects the risk it is suppose to price (given historical context of the spread). The market right now scrambles at deciding whether this is the new normal or not.
- Some research points to recommendations that OIS should not only be used as "risk-free rate" (this term imho should actually be removed from all textbooks) for collateralized portfolios but also uncollateralized ones, in effect replacing libor as curve input.
The biggest change I see and hear fixed income traders talk about is the new ways curves are constructed. The point is that libor itself is of decreasing importance actually. It is the curves that result from adding certain spreads on top of libor curves that matter. If market consensus now shifts to sourcing different rates to construct the base curve then libor rate usage will be phased out gradually.
But keep in mind that a huge amount of derivatives and outstanding rates and even credit products are still based on libor, hence this is not something that will change overnight.
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