maandag 22 augustus 2016

Credit Risk: LIBOR Vs. Fed Funds Rate

The LIBOR rate is a benchmark rate on interbank loans worldwide. It is the amount banks charge each other to borrow money. The counterpart to this is the Fed Funds Rate, which is risk-free.

When both rates diverge from each other, we can say that this is a warning sign for credit risk. It also means there isn't enough liquidity. This is reflected in the higher cost of borrowing from banks.

The Fed has cut rates since the financial crisis of 2008, but LIBOR doesn't follow and is even rising now in 2016, especially since the end of QE3 in 2015. This same thing that happened in 2008 will happen in 2016-2017. LIBOR diverged from the Fed Funds Rate and the Federal Reserve will need to come in and initiate QE4 or negative interest rates to bring down the LIBOR rate and provide liquidity.

Another similar indicator you can follow is the TED spread. The TED spread is the spread between 3-Month LIBOR based on US dollars.

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