Legal Definitions - London Interbank Offered Rate

LIBOR stands for London Interbank Offered Rate. It was a globally recognized benchmark interest rate that represented the average rate at which major banks in London could borrow from other banks in the international interbank market. Essentially, it was an estimate of the cost of borrowing unsecured funds for a short period, typically overnight to one year, across various currencies, though most famously for U.S. dollars (often referred to as Eurodollars when held outside the U.S. banking system).

Financial institutions would submit their estimated borrowing rates daily, and an average was calculated, serving as a critical reference point for financial contracts worldwide. For decades, LIBOR was used to set interest rates on trillions of dollars' worth of financial products, including mortgages, corporate loans, and complex derivatives, before it was largely phased out and replaced by alternative reference rates due to concerns about its reliability and manipulation.

• Example 1: Adjustable-Rate Mortgage (ARM)

  Imagine a homeowner in the early 2000s who took out an adjustable-rate mortgage (ARM). The interest rate on their mortgage might have been set as "6-month LIBOR + 2%". This meant that every six months, the interest rate they paid would adjust based on the current 6-month LIBOR rate at that time, plus an additional 2% margin. If LIBOR went up, their monthly mortgage payment would increase, and if it went down, their payment would decrease. This illustrates how LIBOR directly influenced the cost of borrowing for consumers on a common financial product.

• Example 2: Corporate Floating-Rate Loan

  A multinational corporation might have secured a large, multi-year business loan from a consortium of banks to fund a new factory. The interest rate on this loan could be structured as "3-month LIBOR + 1.5%". This meant that every three months, the interest rate the corporation paid on its outstanding loan balance would reset according to the prevailing 3-month LIBOR rate, plus a fixed spread. This demonstrates LIBOR's role in determining the borrowing costs for businesses, allowing the interest payments to fluctuate with market conditions rather than being fixed for the entire loan term.

• Example 3: Interest Rate Swap Agreement

  Consider two financial institutions entering into an interest rate swap agreement. Bank A might agree to pay Bank B a fixed interest rate on a notional principal amount, while Bank B agrees to pay Bank A a floating interest rate based on "1-month LIBOR". This type of agreement allowed banks or other financial institutions to manage their exposure to interest rate fluctuations, with LIBOR serving as the crucial variable component that determined one side of the payment stream. It highlights LIBOR's use as a reference rate in complex financial derivatives, enabling institutions to hedge or speculate on interest rate movements.