LIBOR Transition to Alternative Reference Rate (ARR)

Here below I will provide a quick introduction on LIBOR transition as a lot of people reached out to me over LinkedIn asking for the same. 

What is LIBOR Transition and how does it impact financial institutions? 

LIBOR interest rate such as LIBOR USD, GBP, JPY, etc... has been the backbone for interest rates markets (derivative or cash products) for almost 5 decades. These rates come in 7 different tenors (Overnight to 1 year) known as term structure of interest rates. However, in early 2000 a consortium of financial institutions manipulated the LIBOR interest rate to profit out of their clients in an unfair way which forced regulators to reform the LIBOR interest rate.

What were the weaknesses in the LIBOR interest rate? 

This rate does not need to be supported by financial transactions which means the participating banks in London can put any rate they desire for the day and that rate would become a global benchmark reference rate. This led to abusive practice by the bank where they could provide any rate to benefit them under "Expert Judgment" and market participants would accept such reference rate without further disputes.

What is the way forward?

Regulators across the globe have taken an aggressive stand and made the following reforms-

1. LIBOR rates are to be discontinued by Dec 2021 with the exception to LIBOR USD for some of the maturity tenors. LIBOR USD to be discontinued completely by June 2023
2. Each LIBOR rate is to be replaced by an alternative reference rate (ARR)
3. Each regulator has taken the responsibility of publishing such rates and hence the administrations of such rates has been taken away from British Bankers Association
4. Alternative Reference rates are nearly risk free and offered in overnight tenor only 
5. These rates are backed by official transactions that take place during the operating hours for the day

What is the ARR for LIBOR rates?

1. LIBOR USD - SOFR 
2. LIBOR GBP - SONIA 
3. LIBOR EURO - ESTR 
4. LIBOR CHF - SARON 
5. LIBOR JPY - TONAR 

OIS Interest Rate and LIBOR-OIS Spread?

What is OIS Rate? 

OIS is an American Rate that is currently being pushed by NY Fed a lot in American markets after the recent global financial crisis. 

This is an interest rate that banks charge each other for an overnight lending to each other. Counterpart to this rate for interbank lending is called LIBOR, which I mentioned in my previous post. 

OIS rate when compared with corresponding LIBOR, is always lower. The rationale is a lending for just an overnight is much more safer than lending to a bank for a longer period say 3M or 1Yr. Since OIS matures overnight, there is a very little risk for counterparty default. This rate is heavily being used primarily in Derivatives instruments where collaterals are being posted by counterparties. 

What is LIBOR-OIS Spread? 

A spread is usually defined as a gap between two attributes such as Gap between two prices or Gap between two interest rates. 

A LIBOR-OIS spread is the gap between LIBOR rate and Overnight Indexed Swap rate. One can imagine that LIBOR will be more riskier than OIS due to longer tenors in LIBOR. The gap can be anywhere between 10-40 bps (1 basis point is 1% of 1%, 100 bp = 1%). In financial market, this gap is closely being monitored for 2 reasons: 

1. If Market sees that banks are still credible but gap is widening then it offers a great arbitrage opportunity for bankers. They can borrow in OIS and Lend in LIBOR.

2. If scenario 1 is not true then it simply means that Financial market is getting into trouble and banks dont feel comfortable in leading to each other for longer periods. 

During financial crisis of 2008, LIBOR - OIS spread jumped from 10-15 basis points to 350 basis points range. Hence, the spread between LIBOR-OIS can be seen as the price of banking risk. 

Hope this helps.

Nitin

LIBOR Interest Rate

What is LIBOR?

In this post I would like to discuss a very important interest rate from UK, LIBOR, that banks in UK use as a Benchmark.

LIBOR - London Interbank Offering Rate

LIBOR is the most important interest rate that is used in LONDON. It is the borrowing rate that banks charge each other for lending various currencies. The rate is published by BBA where the top 16 banks release their rates for charging to other banks and BBA publishes one rate after using some formula behind it.  LIBOR is then used as a benchmark and all financial instruments that require interest rate as a part, would use LIBOR as a benchmark and add some spread based on the credibility. 

In a simple way, consumers will need to pay an interest rate higher than the LIBOR because no one can borrow at LIBOR except the banks themselves. 

These borrowing and lending can happen in any currency such as USD, Euro, Pound and so on. Hence, there is a corresponding LIBOR for USD, EURO, Pound or other currencies. Other than currency, the next important attribute of the LIBOR is the tenor, the duration for which banks want to lend another bank or so. 

Hence, there would be a LIBOR USD rate for 1M, 3M, 6M, 1Y and similarly LIBOR Sterling rate for the same tenor points.

Usage: 

These rates are used as a benchmark to offer various financial instruments to consumers such as Mortgage Rate, Auto Loan Rate, Student Loan and so on and so forth.

Process is very Simple: 

Scenario 01 

Let's say Bank A's can borrow at Libor from Bank B 

Bank A has a customer C1 who wants a short term loan for 1 Yr

Bank A sees the customer C1 to be of less risky and happy to give loan at 0.5% Margin

Finally, Bank will charge Customer C1 an interest rate of Libor + 0.5% + Whatever Processing Fee 

Scenario 02 

Let's say Bank A's can borrow at Libor from Bank B 

Bank A has a customer C2 who wants a short term loan for 1 Yr

Bank A sees the customer C2 to be of more riskier than C1 BUT happy to give loan at 2% Margin

Finally, Bank will charge Customer C1 an interest rate of Libor + 2% + Whatever Processing Fee 

Same process can go for a borrowing in any other currency such as Euro, Sterling and so on. 

Hope this helps,

Nitin

Security Markets Wisdom (Part 4)

Finally, to wrap it all up, I am putting together the thoughts by 2 market leaders, Dennis Gartman and James Montier. 

Again, no matter how many times it has been stressed out that market forces will bring all greed and fear into the equilibrium state as no one can keep on making money all the times. One can think of every state of the market is an equilibrium state for the past and a start of new disequilibrium for future movements. Let me explain it further - Equilibrium from past means that supply and demand would have brought the equilibrium to the price dimension where people would have taken their profits or losses out. Hence, some people would have moved out of the markets due to portfolio ruin and some would have made good profits with their bets. Now to replace the losers, new participants come in and join the market. With new participants, a new combination of greed and fear comes into the play. With new hunger for risk and reward again a disequilibrium will be created causing people to be away from risk adjusted forces. Again, greed and fear will come back in and the same process will keep on going in cycles. 

I am extremely sorry as this final post is going to be a little lengthy so I ask for your patience to scroll until the bottom so that you can fully appreciate the wisdom put forth by these pundits for people such as us. 

Dennis Gartman's Wisdom on Trading Securities

1. Never, under any circumstance add to a losing position.... ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!

2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is "low." Nor can we know what price is "high." Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.

5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

6. "Markets can remain illogical longer than you or I can remain solvent," according to our good friend, Dr. A. Gary Shilling. Don't try to find logic in market movements all the times. 

7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.

8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.

9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.

10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

11. Respect "outside reversals" after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more "weekly" and "monthly," reversals.

12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen... just as we are about to give up hope that they shall not.

14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.

15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first "addition" should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.

16. Bear markets are more violent than are bull markets and so also are their retracements.

17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

18. The market is the sum total of the wisdom ... and the ignorance...of all of those who deal in it; and we dare not argue with the market's wisdom. If we learn nothing more than this we've learned much indeed.

19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.

20. The hard trade is the right trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this twenty five years ago and it holds truer now than then.

21. There is never one cockroach! This is the "winning" new rule submitted by our friend, Tom Powell.

22. All rules are meant to be broken: The trick is knowing when... and how infrequently this rule may be invoked!

Finally, few last ones by James Montier

James Montier's 7 Immutable Laws Of Investing

1. Always insist on a margin of safety

2. "This time is different" is actually never different

3. Be patient and wait for the fat pitch

4. Be contrarian

5. Risk is the permanent loss of capital, never a number

6. "Be leery of leverage". Leverage has been the single most cause of most of the failures of almost all types of trades be it institutional or retailer.

7. Never invest in something you don't understand

I truly hope that this series was a good read to all my dear readers. I am happy to hear your comments, feedback or anything you would like to share. 

-Nitin

Security Markets Wisdom (Part 3)

I hope you have truly enjoyed reading the first 2 parts of the Market Wisdom series. Here, in the part 3, I will talk about Gerlad Loeb and in the final post of the series, Part 4, couple of more guru's sharing to wrap it up.

Gerald Loeb's Wisdom:

1. The most important single factor in shaping security markets is public psychology.
2. To make money in the stock market you either have to be ahead of the crowd or very sure they are going in the same direction for some time to come.
3. Accepting losses is the most important single investment device to insure safety of capital.
4. The difference between the investor who year in and year out procures for himself a final net profit, and the one who is usually in the red, is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures.
5. One useful fact to remember is that the most important indications are made in the early stages of a broad market move. Nine out of ten times, the leaders of an advance are the stocks that make new highs ahead of the averages.
6. There is a saying, "A picture is worth a thousand words." One might paraphrase this by saying a profit is worth more than endless alibis or explanations. . . prices and trends are really the best and simplest "indicators" you can find.
7. Profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed.
8. Willingness and ability to hold funds "non-invested" while awaiting real opportunities is a key to success in the battle for investment survival.
9. In addition to many other contributing factors of inflation or deflation, a very great factor is the psychological. The fact that people think prices are going to advance or decline very much contributes to their movement, and the very momentum of the trend itself tends to perpetuate itself.
10. Most people, especially investors, try to get a certain percentage return, and actually secure a minus yield when properly calculated over the years. Speculators risk less and have a better chance of getting something, in my opinion.
11. I feel all relevant factors, important and otherwise, are registered in the market's behaviour, and, in addition, the action of the market itself can be expected under most circumstances to stimulate buying or selling in a manner consistent enough to allow reasonably accurate forecasting of news in advance of its actual occurrence.
12. You don't need analysts in a bull market, and you don't want them in a bear market

-Nitin

Security Markets Wisdom (Part 2)

I hope you all liked Part 1 of Market Wisdom by Jesse. In Part 2, I will share the facts by another pundit, Bernard Baruch. You would notice, though these people are different, yet they are trying to teach us all the same thing. Discipline and Do not speculate. 

Wisdom by Bernard Baruch-

1. Don't speculate unless you can make it a full-time job.

2. Beware of barbers, beauticians, waiters, taxi drivers — of anyone — bringing gifts of "inside" information or "tips."

3. Before you buy a security, find out everything you can about the company, its management and competitors, its earnings and possibilities for growth.

4. Don't try to buy at the bottom and sell at the top. This can't be done — except by liars. [This is an important fact that bottoms and tops just can't be traded. No one knows about it when they occur. People only know it after the fact and then they would claim how they spotted it. Those who claim to have it spotted very well, must show a history of it to have the skills acknowledged. Else, it was just a pure luck and one shouldn't trade on luck]

5. Learn how to take your losses quickly and cleanly. Don't expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.

6. Don't buy too many different securities. Better have only a few investments which can be watched.

7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects.

8. Study your tax position to know when you can sell to greatest advantage.

9. Always keep a good part of your capital in a cash reserve. Never invest all your funds.

10. Don't try to be a jack of all investments. Stick to the field you know best.

Hope you enjoy it.

Nitin

Security Markets Wisdom (Part 1)

Market Wisdom - In this series I will talk about most of the trading rules that have been shared by market pandits from the past and yet they are been violated in today's world by traders in the hopes of seeing a different outcome.

Trading Securities in markets are primarily driven by two psychological biases - Greed and Fear. Greed lets people take risks that they haven't thought through deep enough and they only appreciate it after seeing it. These excessing greed can lead to either huge drawdowns or entire portfolio ruin.

There have been many market pundits who have shared their wisdom from their own experiences. In this series of "Market Wisdom", I will share what they told us and yet people lack discipline and violate these rules over and over leading to negative returns in Portfolio.

In Post 1 of the series, I will post the infamous "Jesse Livermore's" trading rules that were written back in 1940. All of these rules are taken either from reading books on JL, or through various readings at reliable financial resources websites.

Market Wisdom by Jesse Livermore: 

1. Nothing new ever occurs in the business of speculating or investing in securities and commodities.
2. Money cannot consistently be made trading every day or every week during the year.
3. I become a buyer as soon as a stock makes a new high on its movement after having had a normal reaction.
4. Never buy a stock because it has had a big decline from its previous high.
5. Never sell a stock because it seems high-priced.
6. Markets are never wrong – opinions often are.
7. If you cannot make money out of the leading active issues, you are not going to make money out of the stock market as a whole.
8. The real money made in speculating has been in commitments showing in profit right from the start.
9. As long as a stock is acting right, and the market is right, do not be in a hurry to take profits.
10. One should never permit speculative ventures to run into investments.
11. The money lost by speculation alone is small compared with the gigantic sums lost by so-called investors who have let their investments ride.
12. Never average losses.
13. Wishful thinking must be banished.
14. Big movements take time to develop.
15. Do not become completely bearish or bullish on the whole market because one stock in some particular group has plainly reversed its course from the general trend.
16. It is much easier to watch a few than many. [Don't trade too many different securities]
17. Only a handful of people ever make money on tips. Beware of inside information. If there was easy money lying around, no one would be forcing it into your pocket.
18. The human side of every person is the greatest enemy of the average investor or speculator.
19. It is not good to be too curious about all the reasons behind price movements.
20. The leaders of today may not be the leaders of two years from now. 
21. Don't trust your own opinion and back your judgment until the action of the market itself confirms your opinion.

This is the end of Part 1. Stay tuned for Part 2

-Nitin