Hot Topics in Financial Markets Lecture 1: The Libor Scandal

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1 Hot Topics in Financial Markets Lecture 1: The Libor Scandal Spot and Forward Interest Rates Libor Libor-Dependent Financial Instruments The Scandal 2 Spot Interest Rates Bond Market The yield on a bond is the constant discount rate that equates the present value (PV) of cash flows CF t to the observed market price P of the bond. Find yield y through solving the equation: T t 1 The spot rate R T of maturity T is the yield on a zero-coupon (bullet) bond which pays face value (typically 100) at time T: t P 1 y CF T T P 1 R 100 t Two bonds, same maturity, have different yield only if different coupons

2 Example Treasury Yield Curve Often taken as proxy for riskfree discount rate For bond curves in different credit rating categories (AAA, A, BBB, BB CCC, etc) Moody s, S&P, 3 Fitch Credit Spreads and Creditworthiness A credit spread is the difference between two curves in different rating categories (typically measured relative to AAA or AA) Spreads increase as the credit risk (or creditworthiness ) of the borrower increases (e.g. Greece is rated CCC by S&P) 4

3 Libor What is it? The London Interbank Offered Rate (Libor) is an average interest rate at which a major bank can borrow unsecured funds o for a given period (1d, 1w, 2w, 1m 12m) o in a given currency (USD, GBP, EUR, JPY,.) Calculated daily by the British Banker s Association (BBA) through submissions of interest rates by major banks, globally Currently, you can still download Libor rates from 5 How Libor is Set

4 Historical USD Libor Technology Crash Credit Crunch Credit Boom Banking Crisis Equities stable and trending Sovereign Debt Crisis 7 Spot Interest Rates Libor Curves Curves for different currencies (USD, GBP, EUR, ) consist of: o Money market rates, i.e. Libor and Libid* (short end) o Rates implied from FRAs and interest-rate futures (mid section) o Swap rates (long end) Every day, banks use a mathematical technique to fit an offer curve (for inter-bank borrowing) and bid curve (for inter-bank lending) Difference between curves (offer bid) is the bid-offer spread Credit rating of Libor and Libid curves depends on banks operating in money market 8 * London Interbank Bid Rate

5 Instruments Linked to Libor 1. Loans When setting interest rates for giving loans (e.g. mortgages and student loans) banks may use the official Libor as a base rate and add an additional interest rate (the credit spread) o If banks collude to influence Libor by submitting higher Libor rates for base, they receive more income from their loans But then a bank signals that it has to borrow at a high Libor rate, indicating that it may be in financial difficulties o By submitting lower Libor rates, the perceived creditworthiness of the bank improves 9 Instruments Linked to Libor 2. Floating Rate Notes (FRNs) FRNs are bonds with coupon = Libor + spread Coupons reset after each payment at current Libor rate Investors buy an FRN when they think Libor will rise: o Bond price increases if its coupon increases US Treasury activity in FRM market: o Issued $72 billion nominal of FRNs in August this year o Investor demand remains high on expectations of Libor increase 10 o Further issues of FRNs are planned helps ease $1.21 trillion budget deficit

6 Forward Rates How do we observe them now? No-arbitrage Forward rates are spot rates at some time in the future Derived from spot rates using principle of no-arbitrage e.g. R 1, R 3 = 1-yr and 3-yr spot rates (assume same for bid and offer) F 1,2 = 1-yr forward 2-yr rate = 2-yr spot rate 1 year from now (ditto) A: Borrow/lend 100 for 3 years at R 3 100(1+R 3 ) 3 B: Borrow/lend 100 for 1 year at R 1 then for 2 years at F 1,2 100(1+R 1 )(1+F 1,2 ) 2 No-arbitrage requires that A and B same: (1+R 3 ) 3 = (1+R 1 )(1+F 1,2 ) 2 11 Instruments Linked to Libor 3. Interest Rate Futures Futures contracts, whose settlement price is 100 Libor on settlement date. Hence theoretical price is inversely proportional to forward Libor Used to hedge interest rate risk i.e. lock in an interest rate today for money one intends to borrow or lend in future Exchange traded in large volumes (e.g. Eurodollars on CME) Scalpers keep market price deviations from theoretical price within no-arbitrage range 12

7 Instruments Linked to Libor 4. Forward Rate Agreements (FRAs) OTC agreement to exchange: o a forward Libor rate F 0,T (which is fixed now, time 0) o for floating Libor rate R T (spot rate at some time T in future) Exchange of payments (one side pays other) based on a fixed notional, N (also called face value or principal amount) Note that R T is unknown at time 0 it is a random variable Maturity of interest rates R T and F 0,T is same, e.g. 1w, 12m, 5y,.. Party that pays fixed receives floating pays (F 0,T R T ) x N to the 13 other party Simple Example of FRA Company C has a 6-month $100m loan on which it pays a floating rate but prefers to pay a fixed rate (because it uses accrual accounting more on this later) C enters FRA with Bank B to pay fixed rate F and receive floating (spot 3-month Libor in 6 months time) F = 6m forward 3m Libor rate (observable now) = 5% (say) R = Spot 3m Libor (not known until 6 months from now) In 6 months time C pays (5% R) x $100m to B. In effect, C now pays 5% instead of floating rate R on loan 14

8 1998-H H H H H H H H H H H H H H H H H H H H H H H H H H H H2 Hot Topics in Financial Markets Instruments Linked to Libor 5. Interest Rate Swaps (IRS) 15 Like a series of FRAs Periodic floating interest rate payments of R t (based on Libor) are exchanged for periodic fixed interest rate payments of F (the swap rate) with notional N Swap rate is found by setting the PV of the cash flow on the swap to zero: T t 1 t t PV 1 R CF t Interest Rate Derivatives Growth in Total Market Size Major growth began during credit boom On 31 December 2011 (latest figures) total notional amount outstanding was $500 trillion, i.e. $500,000,000,000,000 i.e. about 7 times annual world GDP!!

9 Instruments Linked to Libor Market Size (Open Interest, 31 December 2011) EUR: $145 trillion IRS: $400 trillion FRAs: $50 trillion CME: $0.1 trillion USD: $125 trillion JPY: $60 trillion GBP: $35 trillion Other: $35 trillion Market size of IRS (and FRAs): $450,000,000,000,000 Hugely greater than exchange-traded IR futures and options (CME) Most IRS are for EUR ($145 trillion) and USD ($125 trillion) 17 What Drives the IRS Market? Accounting Practices Accounting Practice Fixed Rates Floating Rates Company Accrual Not Risky Risky Bank Mark-to- Market Risky Not Risky Typically, banks issue company loans linked to Libor Floating rates not risky for bank, but risky for company 18 Then banks offer companies an IRS to pay fixed and receive floating (banks hedge the IRS risk, e.g. by issuing bonds)

10 Incentives to Manipulate (Rig) Libor Banks have large risk exposures to Libor via the huge IRS market Their traders are, typically, paying a floating (Libor-linked) rate, so they typically profit from lower Libor submissions Lower Libor submissions also improve the perception of their creditworthiness On occasions, the balance of a traders books may be to receive floating rates (e.g. on loans) and in this case it would pay to raise the Libor submission 19 The Libor Scandal Timeline 2005: Barclays traders start trying to rig Libor (FSA report) 2008: Banking crisis Lehman Bros. collapse; in UK Lloyds and RBS are nationalized October 2008: Barclays understand Bank of England asks them to lower Libor fixes (to improve perception of creditworthiness) 2011: Barclays sack 4 traders for attempts to rig Libor June 2012: Barclay s fined 290m ($450m) by banking regulators 20 July 2012: Bob Diamond (CEO) resigns, criminal investigation into Libor rigging begins

11 Barclay s Traders Submitters "Behind the Libor Scandal". New York Times. 10 July During Banking Crisis 22

12 Conclusion August 2012: Barclays, HSBC, RBS, Citigroup, Deutsche Bank, JPMorgan Chase and UBS ordered to testify to US authorities 28 September 2012: Responsibility for setting Libor will be transferred from BBA to FSA Libor submissions must now be supported by relevant trade data and proper record-keeping with greater rigour and transparency Barclays is the only bank to have been fined so far, but it is understood at least 15 banks globally are being investigated for possible Libor manipulation 23

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