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The London interbank offered rate (LIBOR)

Read each post and write a paragraph replying to each one giving your opinion

First Post: Why is LIBOR been replaced?

The London interbank offered rate (LIBOR) is being replaced by the secured overnight financing rate (SOFR). SOFR is preferred over LIBOR since it is based on data from observable transactions instead of estimated borrowing rates. One of the historical events that contributed to the need for this change is that global market has grown in size and complexity while LIBOR methodology has remained largely unchanged. Interest rate swaps on 80 trillion dollars switched to the SOFR in October 2020 making the transition a reality. The long-term goal is to increase liquidity but in the short term it can have a great impact on trading volatility in derivatives. The transition of financial institutions has been slowly; however, it is possible that at this rate LIBOR will end before 2021. Banks are considering value-transfer risk, and assessing contract and portfolios maturing after 2021.

Second Post: What are the key differences between SOFR and LIBOR?

There’s been a slow attempt to transition from LIBOR (London Interbank Offered Rate) to SOFR (Secured Overnight Financing Rate) since 2012, when it was found that some banks were falsifying information to influence the LIBOR rate. Essentially, the LIBOR rate is calculated based on the rate that banks charge each other for loans, or the wholesale unsecured price for inter-bank lending. However, since there were some banks that weren’t actually lending money to each other, this rate wasn’t fully based on transactions that were actually taking place. The SOFR is offered as a solution to this, where the SOFR rate is actually based on loans that are closed, and less likely to be influenced by bank manipulation.

However, there are some differences between the two rates that haven’t been accounted for in this switch. The LIBOR rate can be made for several borrowing periods, while the SOFR rate only covers overnight lending transactions. Therefore, there are a lot of calculations and adjustments to account for in switching the rates. Another difference is that the SOFR will be considered a riskless rate, whereas the LIBOR includes the credit risk involved when borrowing from a bank. Additionally, on the whole, SOFR is historically lower than the LIBOR rate. The LIBOR rate also represents an unsecured rate while the SOFR represents a secured one. Lastly, the LIBOR rate is representative of $500 million in underlying transactions while the SOFR has $1 trillion in underlying transactions.

A useful lesson from this is definitely that even banks can work in corrupt manners to influence interest rates. Essentially, this was to their gain since customers would pay the LIBOR rate, or LIBOR plus additional basis points. Therefore, the banks were working to increase their own interest income, so as consumers it’s good to be aware of these types of practices.

Sample Solution

ountry at a time is very strong” (Schmittmann, 2010). Clearly the currency volatility, and double digit devaluation of the pound would back this statement up. A decision to hedge will ultimately be based on the time horizon of investments held. Froot (1993), similarly looked at the need to hedge from a UK investors perspective in the US markets and argued that currency hedges are less useful at reducing real return variance at long horizons than they are at short horizons. Contrary to this is the work of Statman and Fisher (2003), who found that the mean returns and standard deviation of global portfolios with currency hedging were approximately equal to those with unhedged currencies. Given the assumed IM’s investment time horizon to be medium to long term and not day trading, past evidence suggests no clear advantage of hedging, but again this isn’t a normal market. Correlation & Diversification “The primary motive for international diversification has been to take advantage of the low correlation between stocks in different national markets” Goetzmann, Li and Rouwenhorst (2002). “It is critical to be clear as to exactly why the internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. The gains arise directly from the introduction of additional securities and/or portfolios which are of less than perfect correlation with the securities and portfolios within the domestic opportunity set” (IPTD, no date). It is important to understand a few decades ago it was stated that cross border correlation was low (Grubel, 1968), yet the speed of change in globalisation through information technology and a more connected world, has resulted in more positively correlated stockmarkets between the developed nations. “The level of correlation between the UK and US market is now so high tha
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