 Ask
Dr. Econ
July 2006
Dr. Econ: What is LIBOR and why do LIBOR interest rates
move closely in line with short-term interest rates in the
U.S.?
Good question! To provide the answer, we’ll need to
travel overseas to check out the international money markets.
Eurodollars
Before discussing LIBOR, you should know about Eurodollars.
A good place to start is the Federal Reserve Bank of Richmond
online publication, Instruments
of the Money Market.
Chapter 5 (on Eurodollars) provides the definition for these
deposits:
Eurodollars are bank deposit liabilities denominated in
U.S. dollars but not subject to U.S. banking regulations.
For the most part, banks offering Eurodollar deposits are
located outside the United States.
Eurodollars originated in London during the Cold War but
are now held at banks around the world, and today they constitute
one of the largest short-term money markets in the world.
What is LIBOR?
LIBOR refers to the London Interbank Offered Rate, a money
market interest rate that has become a standard in the interbank
Eurodollar market. The term “interbank” refers
to the fact that this is a market for banks and financial
institutions, rather than individuals or nonfinancial businesses.
However, consumers may be familiar with the term LIBOR because
LIBOR interest rates are commonly used as an index to determine
interest rates on adjustable rate mortgages and business
loans in the United States. LIBOR is defined in Chapter 5
of Instruments of the Money Market:
LIBOR is the rate at which major international banks are
willing to offer term Eurodollar deposits to each other.
An active secondary market allows investors to sell Eurodollar
CDs before the deposits mature.
Eurodollar Rates
Eurodollars provide large U.S. banks with an alternative
to short-term borrowing in the domestic overnight federal
funds market. Mishkin and Eakins explain in Financial
Markets and Institutions, (2000) that because overnight LIBOR and
overnight federal funds interest rates tend to be “near-perfect
substitutes” the interest rates in these two markets
tend to track each other very closely.
In fact, in today’s global financial markets, there
is a strong correlation between short-term U.S. and Eurodollar
interest rates of a similar maturity. You can see this in
the following chart; it shows the very close relationship
between a 3-month LIBOR interest rate (denominated in U.S.
dollars) shown in blue and the 3-month U.S. secondary market
certificate of deposit (CD) rate shown in red.
As you can see, the rates are nearly identical, rarely varying
by more than several basis points over 15 years of weekly
data. As noted in Instruments of the Money Market, in the
competitive money markets, “Arbitrage keeps interest
rates closely aligned between Eurodollar deposits and deposits
with roughly comparable characteristics at banks located
in the United States.”
To check out additional interest rate data, visit the Federal
Reserve Board Statistical Releases listed below as references.
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