Risk-free rates are common subject of debate. If one aims to trade derivates with risk-free rates as their underlying, a reference rate is required on which institutions agree on so that they can do daily business.
EURIBOR and LIBOR reference rates
The EURIBOR and LIBOR serve as reference rates for financial institutions on a daily basis. They are vital to financial markets as they are used as reference rates for pricing financial derivatives. However, practice has shown that they can be unruly. The last financial crisis has shown that these rates cannot however be regarded as truly free of risk.
The risk-free rate must not be considered a constant as it is subject to numerous outside factors. Isolating the risk-free rate from market offered securities or bonds is tricky as variable factors such as credit risk and liquidity must be included.
For this reason, it is useful for issuers of financial instruments to have a common understanding of what risk-free is in a particular moment in time and who sets that rate. The LIBOR and EURIBOR rates are commonly used interest rates that are set and used by numerous banks:
- The LIBOR, or London Interbank Offered Rate is defined daily as an average of rate indications provided by an exclusive set of banks to other banks, on the bases of inter-bank loans.
- The EURIBOR, or Euro interbank offered rate is defined in a similar way, as banks in the eurozone average their interest rates.
The rates quoted by these banks are linked to unsecured debt. The rates are considered risk-free as they are short-term loans among institutions that are considered robust.
The increase of risk in the risk-free rate was observed during the financial crisis in 2008 after mortgage crisis. The LIBOR rates increased vastly as inter-bank trust decreases and their solidity became more ambiguous.
Mortgages were often indicated in LIBOR or EURIBOR with an added spread value. The increase in risk-free rate in the credit crisis caused a positive feedback loop as defaults increased and rates continued to grow.
Risk of collusion using LIBOR rates
The way that the LIBOR rates are calculated using a trimmed mean (see figure above) opens up collusion. In the past, banks have manipulated the daily rates. The height of fines incurred for actions indicate the sheer scale of manipulation, as billions were paid as fines.
For these collusion practice possibilities, alternatives have been proposed. These have however not seen widespread adoption to date.