In the earliest days of the United States, after gaining their independence from England, a genuine debate ensued about the debt that the colonies had accumulated in financing the Revolutionary War. Thomas Jefferson advocated repudiation (defaulting) so that the new nation could pursue its economic development unencumbered by what he considered to be staggering obligations. Alexander Hamilton, though, disagreed vehemently, insisting that this new country had to pay back what it had borrowed (including his recommendation that much of the debt of the individual colonies/states be assumed by the federal government)—calling this debt “the price of liberty.” Hamilton (later Secretary of the Treasury) eventually prevailed, which may explain why he appears on the USD 10 note (as opposed to Jefferson who appears on the nickel or USD .05 coin). Though it has come close once or twice (due to technical political reasons), the United States (excluding the Confederate States of America) to date has never failed to pay on borrowed money. Similarly, Great Britain is recognized as having always honored its debt obligations, and therefore also deserves the designation “risk free.” However, every country cannot claim that distinction. For example, in 1998, Russia simply chose not to pay on its bonds (denominated in Rubles); all Russia needed was paper and ink to redeem their debt, but they simply chose not to. Interestingly, many emerging market governments will issue bonds and other debt instruments denominated in another country’s currency. Presumably that can make those instruments more attractive to a global investor base, but this practice also raises the question of whether that currency will be available on the payment and redemption dates.
At any rate, in just about every country, there is a government or sovereign debt market. In Singapore, even though the government does not need to borrow, they still issue national debt, which serves to provide a (“risk free”) floor to the country’s debt market and, in doing so, establishes a benchmark set of interest rates. The government, therefore, typically provides one “class” of interest rates.
Another extremely important category of interest rates comes from, and applies to, the banking sector. The interest rates to which a majority of over-the-counter interest rate contracts are indexed or tied is the London InterBank Offer Rate (LIBOR). LIBOR as such reflects the rate at which one bank, with solid credit, will lend to another, comparably credit-worthy bank. If I were in New York and heard that LIBOR just went up, I would presume that it referred to USD (Dollar) LIBOR. Of course, there is Yen LIBOR, Sterling LIBOR, Euro LIBOR or Euribor, and several others associated with the major currencies (Swiss Franc, Canadian Dollar, Australian Dollar, New Zealand Dollar, and Danish Krone).
In the spirit of the Olympics, the British Bankers Association (BBA) polls a number of banks in London (seeking their lending quotes on, for example, USD) and then proceeds to throw out the high and low (quartile) quotes—averaging the rest. In this way, the exact USD LIBOR number is viewed as less easily manipulated by a bank that might have an outstanding market exposure linked to the reported interest rate. The results of this process are made available shortly after 11:00 A.M. London time.
You might ask, “Why do we ask London banks what U.S. interest rates are? Why don’t we just ask banks in New York?” Good questions. The real reason that the BBA seeks U.S. Dollar quotes in London is that the major New York banks are all members of the Federal Reserve System (and as such, they are obliged to follow the recommendations of the Fed); Barclays (a U.K.-based bank) can offer its Dollars wherever they want; they are not so constrained from a regulatory point of view. In this sense, then, Barclays (and the other large banks in London) will provide a true, “free market” interest rate for Dollars outside the control of the Federal Reserve System. Because these Dollars are being held by a bank outside the United States, they are sometimes referred to as Eurodollars (and Eurodollar rates are generally viewed as being effectively synonymous with LIBOR).
When one thinks about either borrowing or lending money, it was noted that the interest rate (quoted annually) may be different for different time horizons. This phenomenon is reflected in the fact that the BBA reports a variety of tenors or time frames for USD LIBOR:
Overnight LIBOR
1 week LIBOR
2 week LIBOR
1 month LIBOR
2 month LIBOR
3 month LIBOR
6 month LIBOR
Out to 12 month LIBOR
Due to the dominance of the large (generally AA credit quality) money center banks in the FX markets, the presumption is that LIBOR indicates their correct cost of funding and so, in the calculations that follow throughout this book, we presume that the interest rate reflects the proper currency and time horizon for one of these LIBOR-based banks. After all, it is likely to be a bank’s trading desk that takes advantage of an opportunity or arbitrage situation in FX (and less so that of a central bank or a subinvestment grade corporation).
Read More : Interest Rates In The Real World
