LIBOR (London Interbank Offered Rate) is a benchmark interest rate that is used to set the interest rates on a wide range of financial products, including securitisations. LIBOR is calculated by a panel of banks that submit their estimates of the interest rate at which they would be willing to lend unsecured funds to other banks in the London interbank market.
LIBOR is used in securitisation transactions in a number of ways, including:
- To set the interest rates on the securities: The interest rates on the securities issued in a securitisation transaction are often linked to LIBOR. This means that the interest rates on the securities will fluctuate in line with LIBOR.
- To calculate the cash flows on the securities: The cash flows on the securities issued in a securitisation transaction are often calculated using LIBOR. This means that the cash flows on the securities will be based on the interest rates that are prevailing in the London interbank market.
- To hedge the interest rate risk: The interest rate risk on a securitisation transaction can be hedged by using LIBOR-linked derivatives. This means that the investors in the securitisation can protect themselves against changes in LIBOR.
LIBOR is a widely used benchmark interest rate, but it has been criticized for being susceptible to manipulation. In 2012, a number of banks were fined for manipulating LIBOR. As a result, there is a move away from LIBOR and towards other benchmark interest rates, such as the Secured Overnight Financing Rate (SOFR).
Here are some of the applications of LIBOR in securitisation:
- To securitise floating-rate assets: LIBOR is often used to securitise floating-rate assets, such as mortgages and loans. This is because the interest rates on the securities issued in the securitisation transaction will fluctuate in line with LIBOR, which will match the cash flows on the underlying assets.
- To securitise fixed-rate assets: LIBOR can also be used to securitise fixed-rate assets, such as bonds. This is done by using a process called interest rate hedging. Interest rate hedging involves using derivatives to lock in the interest rates on the securities issued in the securitisation transaction, even though LIBOR may fluctuate.
- To create synthetic securitisations: Synthetic securitisations are securitisations that are not backed by any underlying assets. Instead, the cash flows on the securities issued in the securitisation transaction are derived from LIBOR. Synthetic securitisations are often used to hedge interest rate risk.
LIBOR can be a valuable tool for securitisation transactions. It can be used to set the interest rates on the securities, calculate the cash flows on the securities, and hedge the interest rate risk. However, it is important to be aware of the limitations of LIBOR and the move away from it.