Exchange rate calculation and LIBOR effects

Supply and demand will determine the price of foreign currency.

Base currency is the fixed currency. Either in direct or indirect

There are 3 types of rates 1. Spot/ cash rate 2. Cross rate 3. Forward rate

Spot rate is the rate which is used on the spot transaction.

Three things are considered to determine rate, thereby implicitly draw demand and supply curve.

1.      Cost of fund-deposit rate

2.      Cost of administration—in our country banking industry average is 3-3.50%

3.      Cost of capital- what owner wants-say 2%

'

Demand and supply will be determined based on the above criteria.

The rate used in the Interbank Foreign Exchange Market is the cost of fund—buying price (DIBOR) Libor

Say rate in interbank==   77.50   ----77.70

To determine buying rate deduct cost of admin + cost of capital, say, $ 0.10 and $ 0.05 respectively and 77.50 is the cost of fund      (buy low and sell high.)

So, cash/ spot buying rate will be 77.35  and selling 77.85 by adding all three.

The above is my spot/ cash rate based on which all other rates will be determined.

3 million overbought/ long position=buying is higher than selling

Oversold/ short position=selling is higher than buying ( all book transfer, so selling can be higher than buying)  (for me short bought)

Squre up position==keeping selling and buying same

No bankers are allowed to leave office without square up. Dealers can sell outside the office by phone.

LIBOR Defined

LIBOR is by far the most widely-used benchmark for short-term interest rates in the world and in the United States.  LIBOR is the average rate at which banks can borrow short-term rates from each other and is used as the index for the vast majority of loans and deposits world-wide.  There are currently up to 18 contributing banks for five major currencies (US$, EUR, GBP, JPY, CHF), and for seven different maturities.  A total of 35 rates are posted every business day (five currencies times seven maturities).  The US dollar 1 and 3-months are the most common quoted rates in the world.

LIBOR is used as the benchmark reference rate for debt instruments, including government and corporate bonds, mortgages, student loans, and credit cards. 

 Why Your Bank Should Use Libor Instead of Prime

Every banker is familiar with the Prime rate, and most community banks do not have many loans or deposits tied to LIBOR.  The question comes up – should you have more LIBOR loans? The answer is a clear yes and while LIBOR is slightly harder to explain to some borrowers, there are 6 good reasons to switch from Prime to LIBOR.   

First, LIBOR has more influence on bank financial performance than Prime. 

Second, in some instances, LIBOR-based loans can reduce operational overhead for banks.

Third, banks can reduce basis risk by using LIBOR instead of Prime. 

Risk Management

Prime may or may not move in connection with the market, but LIBOR, on the other hand, is a market rate and changes to reflect both interest rate changes and systemic credit changes. Further, because of this close correlation, banks that are on top of their risk management game convert all indices in the bank back to the LIBOR / swaps curve. In this manner, banks can have a single reference point to understand the base rate for all loans, deposits and fees. This simplifies risk management as banks more easily compare how the spread movement of say their certificates of deposits compare to their loans based on FHLB advance rates or Treasuries.  

  Fourth, in a rising rate environment LIBOR-based loans are more profitable than Prime-based loans. 

How LIBOR Can Help Banks

In a rising rate environment, LIBOR is a better index for lenders.  Because if LIBOR anticipates  that Fed will increase its rate, LIBOR will rise before Prime does.  For example, a LIBOR-based loan portfolio, with an identical nominal yield today will earn the lender four to eight basis points more per annum than the same loan portfolio priced to Prime (four to eight basis points is dependent on the LIBOR maturity used and how many times the Fed raises rates next year).  In a very competitive lending environment, eight basis points is meaningful - $80k per $100 million loan portfolio.

 Fifth, where Prime is an administrative rate, LIBOR is a market rate, and thus a better reflection of risk.

Sixth, because of the above. LIBOR-based loans are more marketable should you ever want to sell and thus more liquid.

2012 LIBOR Scandal

Before ICE took over, the British Bankers' Association (BBA) managed LIBOR. It comprised the rate from a panel of banks representing countries in each of the quoted currencies. The banks were asked what rate they would charge for a given currency and a given length of time. BBA trusted that the rates quoted by the banks were the actual ones.

In 2012, Barclays' bank was accused of falsely reporting lower rates than they were actually being offered during the period 2005-2009. As a result, Barclays' was fined $450 million, and its CEO Bob Diamond resigned. However, Mr. Diamond said that most other banks were doing the same thing, and that the Bank of England knew about it.

Why would Barclays', or any bank, lie about its LIBOR rate? It could make higher profits, because a low LIBOR rate is seen as a mark that the bank is more sound than one with a higher LIBOR rate. Since Barclays' submitted a lower rate, you might have benefited, too. A lower LIBOR rate translates to a lower interest rate on many adjustable-rate loans. (Source: Business Live, Barclays' Defense on LIBOR Fixing, July 4, 2012)