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Libor
The interest rate that most international banks charge each other for loans in Eurodollars overnight in the London market.
Libor is a global rate benchmark for floating-rate consumer and corporate loans, It is also a basis for numerous exchange-traded and over-the-counter financial instruments.
London Interbank Offered Rate (or LIBOR, pronounced LIE-bore) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). LIBOR will be slightly higher than the London Interbank Bid Rate (LIBID), the rate at which banks are prepared to accept deposits.
Measuring banking trust
Relationship between 3-month LIBOR and Fed Funds Rate
You can use the gap (difference) between the 3-month Libor rate and the Fed Funds Rate to measure the amount of trust (or distrust) that banks have in lending money to each other. The greater the gap, the less trust, as can be illustrated in the following graph. It shows a widening gap as the credit crisis reached a worrying level in Septemeber 2008:
LIBOR-based derivatives
Eurodollar contracts
The Chicago Mercantile Exchange's Eurodollar contracts are based on three-month US dollar LIBOR rates. They are the world's most heavily traded short term interest rate futures contracts and extend up to 10 years. Shorter maturities trade on the Singapore Exchange in Asian time.
Interest Rate Swaps
Interest rate swaps based on short LIBOR rates currently trade on the interbank market for maturities up to 50 years. A "five year LIBOR" rate refers to the 5 year swap rate vs 3 or 6 month LIBOR. "LIBOR + x basis points", when talking about a bond, means that the bond's cash flows have to be discounted on the swaps' zero-coupon yield curve shifted by x basis points in order to equal the bond's actual market price. The day count convention for LIBOR rates in interest rate swaps is Actual/360.
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