Legal Definitions - LIBOR

LIBOR stands for the London Interbank Offered Rate.

LIBOR was a globally recognized benchmark interest rate that represented the average rate at which leading banks in London were willing to lend to one another in various major currencies and for different maturities (e.g., overnight, one month, three months). For decades, it served as a critical reference point for setting interest rates on a vast array of financial products worldwide, including adjustable-rate mortgages, corporate loans, and complex derivatives. However, due to concerns about its integrity and potential for manipulation, LIBOR has been largely phased out and replaced by new, more robust alternative reference rates (ARRs) in most major currencies.

Here are some examples illustrating how LIBOR was used:

• Adjustable-Rate Mortgage (ARM): Imagine a homeowner who took out an adjustable-rate mortgage in the early 2000s. The interest rate on their mortgage might have been structured as "3-month LIBOR + 2%." This meant that every three months, their mortgage interest rate would reset based on the prevailing 3-month LIBOR rate at that time, plus an additional 2%. If LIBOR went up, their monthly mortgage payments would increase, and if LIBOR went down, their payments would decrease. This demonstrates how LIBOR directly impacted consumer lending products.

• Corporate Loan Agreement: A large manufacturing company secured a multi-million dollar variable-rate loan from a consortium of banks to fund a new factory expansion. The loan agreement stipulated that the interest rate would be "6-month LIBOR + 1.5%." Every six months, the interest rate on the outstanding loan balance would adjust according to the then-current 6-month LIBOR rate, plus the agreed-upon spread. This illustrates LIBOR's role in determining the cost of borrowing for businesses in the corporate finance market.

• Interest Rate Swap: Two financial institutions, Bank A and Bank B, entered into an interest rate swap agreement. Bank A agreed to pay Bank B a fixed interest rate, while Bank B agreed to pay Bank A a floating interest rate tied to "1-month LIBOR." This type of derivative contract allowed both banks to manage their exposure to interest rate fluctuations, with LIBOR serving as the crucial benchmark for the floating leg of the swap. This example highlights LIBOR's extensive use in sophisticated financial markets for hedging and speculation.