LIBOR Term Rates Versus Overnight Policy Rates
Summary
The document distinguishes LIBOR from an overnight policy rate such as the UK’s SONIA. LIBOR represents a term borrowing rate for a specified maturity, while the policy rate applies to overnight lending. The distinction explains why an overnight central-bank rate does not directly supply the same information as a three-month interbank borrowing rate.
It also explains that term rates may rely on bank submissions when there are too few transactions across maturities to provide a reliable observed rate. Those submissions can be affected by banks’ incentives and market positions, so they are not equivalent to a broad set of directly observed trades. The document notes LIBOR’s role as a reference rate for derivatives, but gives no detailed account of its calculation, governance, or limitations beyond the thin transaction data and potential reporting bias described.
Key ideas
- LIBOR is a term borrowing rate, whereas SONIA and federal funds are overnight rates.
- An overnight policy rate does not directly represent borrowing costs over longer maturities.
- Bank submissions may be used when transactions at a particular maturity are insufficient for a reliable market rate.
- Submitted rates can reflect reporting incentives and banks’ market positions.
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Full text
# Why is there a need for Libor in the UK # Why is there a need for Libor in the UK In the US, the Fed determines the federal funds rate, which is used by banks to lend money to each other. In the UK, I am assuming the Central Bank has the same role. So why then is there a need for Libor? Libor is aimed at asking the banks how much it would cost them to borrow from other banks. Why ask them, when these costs are already settled by the Central Bank? ## Answer by dm63 (score 2, accepted) https://quant.stackexchange.com/a/35366 Libor is a term rate (eg 3 month libor is the rate at which banks would lend to each other for 3 months). Fed funds (or Sonia in the UK) is an overnight rate. That's the difference. ## Answer by Alex Taha (score 1) https://quant.stackexchange.com/a/35367 The reason banks are asked rather than the rate being observed is that transactions do not take place for all of those maturities, at least not with enough banks to make it accurate at any given time. So the best that can be done is ask them at what cost they can borrow and surely each has a bias to either overstate or understate depending on their market positions. Although in general you would not want to tell the market you think you can borrow at a high rate as that will cause the market to expect a higher rate from you. Libor is the underlying for trillions of derivatives contract and serves a very important function. Like a lot of things in finance such as MTP, we can criticize it a lot but it may be the best we have at the moment...
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.