My Column: Everything you need to know about Interest Rates

Interests Rates explained briefly:

With the many different Interest Rates floating around, the jargon can become intimidating. This column explains the basics of Interests Rates and swaps.

What are interest rates?

An interest rate simply, is the rate at which a buyer pays money to his/her lender. It is a commonly perceived notion that the value of money decreases with time; in other words, £100 will not be able to buy as much in the future, as today. Hence, if I’m lending someone £100 pounds today for 6 months (with which I can buy 25 pints of good seasonal ale!), I would want back, say, £110, because in 6 months from now, £100 wouldn’t be able to buy as much.

The two major categories of interest rates are floating and fixed rates. A fixed rate is simple to understand- the lender gives back the borrower a fixed percentage of the total amount back as interest (in the above example, 10% for 6 months). The floating rate is slightly more complicated and is usually expressed as a sum of a fixed percentage and an interbank lending rate (which I will explain about shortly). As an example, a 6-month floating rate could be: LIBOR + 8.5%. The borrower will pay back, in 6 months, the London inter-bank rate (bear with the jargon for a few more lines!) plus 8.5% as interest.

What is the LIBOR?

LIBOR, or the London-interbank offered rate is the rate at which a major financial institution (such as a big bank) is ready to lend money to another major financial institution. This is calculated every morning (at around 11 AM), after these financial institutions (major banks in London) submit their figures to a central body; LIBOR, thus changes every day (hence, floating). Banks borrow money for various activities, and pay back their lenders at different interest rates. The LIBOR is meant to reflect the average of all these rates. LIBOR is calculated for different time scales (1 day, 1 week, 6 months etc.). Typically, LIBOR is the bench mark rate; hence, most commercial lending rates are calculated as LIBOR + a premium. Similar to LIBOR, there is also a EURIBOR rate (European Banks), as well as EONIA which I will explain and compare shortly.

 

Why are Interest Rates traded on markets, and what are Swaps?

Interest Rates may be traded in a variety of ways, such as forwards, swaps etc. The major reasons for trading interest rates are: to either hedge your exposure; or to speculate on the direction of market movement. Ok, but what the hell does that mean?

As an example, let’s assume I’m a major bank, say, JP Morgan; I am owed money by my borrowers in 3 months time and they will pay be back £10mn at an 8% fixed rate. However, I am meant to pay my lenders £10mn, at a floating rate of LIBOR + fixed amount. I am worried that LIBOR might shoot up in 3 months time, so my position is exposed here, as I’m receiving a fixed amount, but am paying a variable amount. Should the LIBOR shoot up in 3 months time, I will be liable to pay a lot more than what I am owed. I’d like to cover my position by fixing my obligations. What I can do to achieve this is to enter an Interest Rate swap with (another bank), say, Goldman Sachs who are willing to pay me at a floating rate, in exchange for me paying them at a fixed rate. The motivation for Goldman Sachs to enter this agreement will be similar; they might be looking to cut their exposure to a fixed rate, rather than a floating rate; or they might be speculating on the LIBOR to go down. The flowchart in this post will make things more clear.

Hence, I am basically borrowing and paying at fixed rates (although paying an extra 0.5% to Goldman Sachs because I feel that LIBOR is going to rise by more than that figure), while whatever I receive from Goldman Sachs covers for my obligations. This is one of the very simple of a class of products called Interest Rate Derivatives. I will not go into more detail about Interest Rate Derivatives in this article.

So, what are EURIBOR and EONIA?

EURIBOR (barring logistics) is essentially to Europe, what LIBOR is to the UK. These rates are only based on banks’ quotes every morning. These loans represent the rate at which a bank can obtain an unsecured loan in the inter-bank market. The banks do NOT post any collateral with regards to these loans figures; hence, these rates are risky.

EONIA, on the other hand, (the European Overnight Index Average) is another commonly traded IR. This is computed as a weighted average of all unsecured lending transactions overnight. Note, here, this rate is computed from actual transactions in the market, hence, cannot be over or under-stated. EONIA is considered a ‘safer’ IR than the LIBOR or the EURIBOR.

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One thought on “My Column: Everything you need to know about Interest Rates

  1. Pingback: 19 July 2012: Stocks firm up, Mizuho to pay CDO charges | The Daily Mundane

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