When USD LIBOR Is Useful and Why It Is Not Risk-Free
Summary
The document discusses whether USD LIBOR, derived from panel banks’ unsecured interbank lending rates in London, can serve as a measure of short-term US interest rates. It gives two perspectives: the international makeup of contributing banks supports its relevance to dollar funding, while its purpose and embedded risks determine whether it is suitable for a particular model.
The key caveat is that LIBOR includes compensation for interbank credit and liquidity risk, so it should not be treated as a risk-free rate. The response suggests short-term US Treasury rates when a risk-free input is needed, with the appropriate maturity depending on the model. Federal Funds and the LIBOR–OIS spread can also help contextualize the rate. The discussion is a conceptual guide and does not provide a quantitative comparison or address later changes to benchmark-rate conventions.
Key ideas
- USD LIBOR reflects unsecured dollar interbank funding, even though it is set in London.
- Its usefulness depends on the intended application and the model’s rate input.
- Interbank credit and liquidity premiums make LIBOR unsuitable as a risk-free rate.
- Short-term US Treasury rates may be more appropriate for risk-free modeling, depending on duration.
- Federal Funds and the LIBOR–OIS spread provide additional context for interpreting LIBOR.
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Full text
# Does LIBOR in USD reflect short term interest rates in the U.S.? # Does LIBOR in USD reflect short term interest rates in the U.S.? The London Interbank Offered Rate (LIBOR) is an indicative average interest rate at which a selection of banks (the panel banks) are prepared to lend one another unsecured funds on the London money market. LIBOR is currently calculated for 5 different currencies, including the USD. If LIBOR denominated in USD is calculated based on London based banks, is it still a good short term interest rate measure for the U.S.? ## Answer by Sason Torosean (score 3, accepted) https://quant.stackexchange.com/a/27634 It depends on the purpose for which you want to use LIBOR. If you want to use it as a measure of risk free rate, then it is not a good idea, because it included premiums for interbank lending credit risk and liquidity risk. You should use the rate on short term US treasuries for risk free rate (again it depends on the duration of your model). You can also check out Federal Funds rate and how it relates to LIBOR (LIBOR-OIS Spread) to get a better feel for what interest rate you would need. ## Answer by Richard (score 2) https://quant.stackexchange.com/a/27637 Yes, in general it is. If you take a look at the banks that contribute to the Libor you'll see why: - Bank of America - Bank of Tokyo-Mitsubishi UFJ - Barclays Bank - BNP Paribas - Citibank NA - Credit Agricole CIB - Credit Suisse - Deutsche Bank - HSBC - JP Morgan Chase - Lloyds Banking Group - Rabobank - Royal Bank of Canada - Société Générale - Sumitomo Mitsui Banking Corporation Europe Ltd - Norinchukin Bank - Royal Bank of Scotland - UBS AG It consists not only of british banks, but of banks from all over the world. It does well as an approximation for the short term interest rate, since lending to other banks is relatively low in risk and therefore corresponds to a lower interest. But, as Sason already mentioned, I would not use it as a risk free rate.
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