Wednesday, February 6, 2013

LIBOR and Derivatives – how close are they?


LIBOR and Derivatives – how close are they?
By Jasvin Josen
This article appeared in The Edge on Dec 3, 2012

We are quite familiar with the recent LIBOR (London Interbank Offered Rate) scandal in the financial markets. The obvious effect of the manipulation of the LIBOR is to mortgage loans and corporate loans. However, there was a bigger concern that LIBOR was integrated into approximately USD350 trillion worth of derivative contracts globally.
LIBOR affects derivatives in more that one way. Firstly, interest rate derivatives use LIBOR to determine their payoffs at certain dates. Secondly, all derivative positions are priced using LIBOR, where LIBOR is used as the discounting rate.

Interest rate Derivatives
Interest rate derivatives have payoffs depending on interest rate levels. For example if an investor buys the CME Eurodollar Future, his profit from this derivative will depend on what level the 3-month USD LIBOR is.

Other common interest rate derivatives are interest rate forwards (also known as forward rate agreements or FRAs), interest rate swaps, interest rate options and structured rate products. In this 2-part article series, I demonstrate how LIBOR can affect interest rate swaps, interest rate options and structured rate products.