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Looking at the LIBOR number itself is useful, but you shouldn't stop there. Check out what you can learn by digging into how the LIBOR is calculated.
LearningMarkets.com Video
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{loadposition wadebyline} Digging Into the LIBOR Number
Each market day, the British Banker's Association (BBA) releases the a single London Interbank Offered Rate (LIBOR) that tells investors the average price banks are charging each other for U.S.-dollar denominated loans. While this number---which gives us a glimpse into the health of the global banking system---is extremely important, it doesn't tell you the whole story.
To get the whole story, you have to dig into how the LIBOR is calculated.
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The LIBOR Spread
To calculate the LIBOR each day, the BBA surveys 16 different banks to find out what rate each one is charging for its overnight loans made to other banks. [Learn more about LIBOR and how it is calculated.]
Naturally, each bank is going to have a unique rate it is charging. For example, on May 27, 2009, the 16 banks the BBA surveys were charging the following interest rates:
- Bank of America:
0.65 percent
- Bank of Tokyo-Mitsubishi UFJ Ltd:
0.73 percent
- Barclays Banks plc
0.63 percent
- Citibank
0.65 percent
- Deutsche Bank AG
0.62 percent
- HSBC
0.63 percent
- JP Morgan Chase
0.62 percent
- Lloyds Banking Group
0.66 percent
- Mizuho Corporate Bank
Unavailable at this time
- Norinchukin Bank
0.73 percent
- Rabobank
0.67 percent
- Royal Bank of Scotland Group
0.72 percent
- Societe Generale
0.68 percent
- Sumitomo Mitsui
Unavailable at this time
- UBS AG
0.73 percent
- WestLB AG
0.68 percent
As you can see in the list above, the Bank of Tokyo-Mitsubishi UFJ Ltd. and UBS AG are charging the highest rates---0.73 percent---while JP Morgan Chase is charging the lowest rate---0.62 percent.
The difference between the highest rate---0.73 percent---and the lowest rate---0.62 percent---is the LIBOR spread, which in this case is 0.11 percent (0.73% - 0.62% = 0.11%).
This is a relative large spread compared to how low the overall LIBOR rate is.
When the LIBOR spread is high, it shows there is more concern in the banking sector that not all of the banks are on sound footing and there is a heightened default risk. When the LIBOR spread is low, it shows there is less concern in the banking sector that not all of the banks are on sound footing and there is a low default risk.
The LIBOR spread is an often overlooked piece of information that gives us an idea of how healthy the banking system really is. Remember, banks may say they are doing well and they believe other banks are as well, but when the rubber hits the road, you can really tell how banks feel about other banks by looking at the interest rates they charge them when borrowing funds.
“Interest,” “roll-over,” “tomorrow-next,” and “cost of carry” are all terms used by dealers to describe the premium paid, or charged, on each currency pair.
Each currency pair has an interest payment and charge associated with holding the position long or short. For some pairs, you may receive a payment if you are in a long position and pay a charge if you are short the pair.
But for other pairs, you may receive an interest payment if you are short and pay a charge if you are long the pair. Some dealers list the premiums and charges you receive or pay within their trading software, while others list the premiums and charges on their website. These premiums and charges can change on a daily basis but will typically not change very much.
So how do dealers determine what rates they are going to charge and pay? Dealers derive the interest premiums and charges they use from the difference in the short-term interest rates of the two economies represented by the currencies in the pair you are trading. The short-term interest rate typically used is the overnight LIBOR rate. LIBOR rates are set by the British Banker’s Association (BBA) and are updated on a daily basis.
Let’s take a look at the interest premiums and charges that were once paid and charged on the AUD/USD for example.
Imagine that you were long one contract of the AUD/USD and the current interest rates, as defined by the overnight LIBOR rates, were 6.67 percent and 4.28 percent, respectively. When you are long the AUD/USD, you are actually long the Australian dollar (AUD) and short the U.S. dollar (USD) and will benefit as the AUD rises in value relative to the USD. If you were to net those two interest rates, multiply that amount by the total amount of the base currency and then divide that number by 360, you arrive at a close approximation of the interest premium.
Step 1: Determine the difference between the overnight LIBOR interest rates of the two currencies involved in the pair. (AUD 6.67%) – (USD 4.28%) = 2.39%
Step 2: Multiply the difference between the two interest rates by the amount of the base currency you have tied up in your trade 2.39% × 10,000 (one mini-lot) = $239
Step 3: Divide the amount in step 2 by 360 days to determine the interest payment amount in the base currency 239/360 = 0.66 AUD
Step 4: If the base currency is different than the currency you hold your account in, use the current exchange rate between the base currency and your account currency to convert the amount into your account currency (0.66 AUD x 0.8685 = $0.57)
If you were short the AUD/USD, you would reverse this equation and find the amount you would be charged to be holding the position.
That sounds pretty good, and it is. However, because you are working with a dealer, you will find that they are paying you a little less than you may have expected, and they are also charging you a little more. Dealers take a portion of the interest premium as part of their service charges to you, the trader. The actual premium paid on any single position will vary a lot from dealer to dealer and with different account types.
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Interest premiums are paid in different ways, depending on the dealer.
The most common ways that dealers pay, or charge, interest in through an actual cash payment—which can be approximated with the calculation above—or by resetting your entry price to a new price. The process of resetting your entry price means that if you were long a currency pair and are owed a premium, your entry price is reset to be lower (i.e. better off) than when you first entered the trade. Likewise, if you were short a currency pair and are owed a premium, your entry price will be reset to be slightly higher (i.e. better off) than it was when you first entered the trade.
Conversely, if you were long a currency pair and owe an interest payment, your entry price is reset to be higher (i.e. worse off) than when you first entered the trade. Likewise, if you were short a currency pair and owe an interest payment, your entry price will be reset to be slightly lower (i.e. worse off) than it was when you first entered the trade.
In the AUD/USD example above, if your dealer was resetting your positions rather than making a cash payment, your long entry position would have been reset by .000057—or a little more than half a pip. That means that instead of receiving a cash payment, your net profit in the position went up a little because your entry price was set to a more favorable level.
While it is common for these payments and charges to be made somewhere between 10:00 pm and 12:00 am GMT, they vary by dealer. In some cases, dealers spread the premium into a continuous payment based on how long you held the position. Like many things in the forex market, it is also important to understand how dealers compete based on these rates. You should also understand some of the pitfalls you can avoid related to this premium.
Consider these tips to get the most out of your dealer:
Tip #1 – Most dealers will pay more if you are willing to carry a lower maximum leverage rate in your account. That means that if you are willing to have a maximum leverage rate of 50:1 instead of 200:1, your dealer will pay you a higher premium and charge you a lower interest rate on the other side of the transaction. Since a 50:1 leverage rate is still extraordinarily high and will probably never be maxed out in your own account anyway, this is a good deal for you. Over time, the difference in interest paid and interest charged can be very large.
Tip #2 – On Wednesdays, the interest premium is triple the normal amount. That may make a difference in your trade timing if you are considering a currency pair with a very high interest payment/charge. This is done because the market is essentially closed on Saturday and Sunday so the value date is extended to Monday.
Tip #3 – The premium payment is one of the factors dealers will use to compete for your business. If you are trading a strategy, such as the carry trade, which relies on high interest payments, you should consider opening an account with the dealer offering the most consistently attractive premiums for that particular strategy. You may also want to consider opening different accounts with different dealers. Having an account with more than one dealer can be a very good thing and can help you take advantage of each dealer’s strengths.
Tip #4 – Some dealers will give you a better rate if you CALL THEM AND ASK FOR IT. If you are working with a dealer you like but the premium seems low, call and find out what it takes to get the higher rate. You may be surprised by what they are willing to do for you. Remember who works for whom.
Make sure to watch the video above, and then continue to Margin and Leverage
{loadposition wadebyline} Why are Economists Worrying About a Rising LIBOR?
In the midst of the largest financial crisis since The Great Depression, you are probably hearing a lot about LIBOR rising—which is a sign that the global credit markets are seizing up because banks are afraid to loan to each other because they don't know if the other banks they are loaning to are going to exist next week, let along be able to pay back those loans. But what on earth is LIBOR?
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London Interbank Offered Rate (LIBOR)
The financial markets are full of acronyms, and one of my favorites is LIBOR. The acronym LIBOR stands for London InterBank Offered Rate. This is the average interest rate that banks charge when they make short-term unsecured loans to other banks.
Unlike the Federal Funds Rate or the Discount Rate, which are both set by the U.S. Federal Reserve, nobody "sets" the LIBOR rate. Instead, the British Bankers' Association (BBA) surveys 16 different major banks and asks them what rate they are charging other banks to borrow money. Once they have compiled the results, they take an approach similar to the judges who score Olympic diving take—they throw out the four high scores (or rates) and throw out the four low scores and then find the average of the remaining eight scores. Here's how it works:
Imagine the BBA goes out, surveys its 16 banks and ends up with the following interest rates being charged by each bank:
- Bank #1 — 3.87% - Bank #2 — 3.85% - Bank #3 — 3.81% - Bank #4 — 3.76% - Bank #5 — 3.75% - Bank #6 — 3.74% - Bank #7 — 3.71% - Bank #8 — 3.69% - Bank #9 — 3.67% - Bank #10 — 3.66% - Bank #11 — 3.63% - Bank #12 — 3.62% - Bank #13 — 3.60% - Bank #14 — 3.57% - Bank #15 — 3.53% - Bank #16 — 3.48%
In this case, the BBA would throw out the top four rates (Banks 1–4) and the bottom four rates (Banks 13–16) and then average the rates from the remaining banks (Banks 5–12) to come up with a LIBOR rate of 3.68 percent.
The BBA conducts these surveys and then calculates the LIBOR rate once a day at about 11 am London time.
What Does LIBOR Tell Us?
When LIBOR is rising, it tells us one of two things: 1) it tells us that interest rates in general are rising and thus LIBOR is also rising, and/or 2) it tells us that lending banks believe the banks they are lending to have a higher risk of defaulting on the loan so the lending bank has to charge a higher interest rate to offset this risk.
When LIBOR is falling, it tells us one of two things: 1) it tells us that interest rates in general are falling and thus LIBOR is also falling, and/or 2) it tells us that lending banks believe the banks they are lending to have a lower risk of defaulting on the loan so the lending bank does not have to charge a higher interest rate to offset this risk.
You can also compare LIBOR to other indicators to conduct spread analyses. Learn more about one of the most often used spreads using LIBOR in Understanding LIBOR-OIS Spread.
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