Benchmark rates are rates or the prices of instruments that are traded in the market which are used for pricing of other instruments. These rates or prices are used as benchmark for floating rate instruments. In the fixed income market, it is an interest rate that the market respects and closely watches.
Typically a benchmark rate should satisfy the following criteria:
I. The rate should be truly representative of the market – in terms of span and weightage.
II. The rate should be readily available and should either be directly observable in the market or made available by a credible agency.
III. The benchmark should be liquid so that counter-hedging strategies are readily available.
IV. The rate should be unique and leave no scope for ambiguity.
A call money reference rate can find the following applications:
a. Traders can make many decisions as offsets compared with the prevailing reference rate.
b. Derivatives require a clearly defined reference rate as a foundation, of which the pay-off from the derivative is defined.
c. A variety of contracts can be structured as offsets from future levels of a reference rate. The example may be a floating rate bond that uses an interest rate which is given ‘n’ offsets above a given reference rate.
Internationally the most popular benchmarks are the London Inter-Bank Offer Rate (LIBOR) and the US Treasury.
LIBOR:
The London Inter Bank Offer Rate (LIBOR) is one of the most used benchmark rates since 1960s. LIBOR is based on the interest rates at which banks offer to lend unsecured funds to other banks in London wholesale inter money market. It is a reference rate for various financial products like syndicated external loans across currencies such as external commercial borrowings (ECBs) and foreign currency convertible bonds, interest rate futures and credit derivatives.
LIBOR is calculated by pooling the quotations given by 16 large banks in the city of London and published at around 11 am London time every day, before the opening of the US stock market. The quotations are ranked in the order of magnitude, the four highest and four lowest quotes are ignored and LIBOR is then calculated by averaging the remaining eight quotations.
The British Bankers Association (BBA), which publishes this rate every day. Following the sub-prime crisis that forced banking sector to write down losses worth billions of dollars and the consequent credit crunch in the global market. On the bankers complaint that LIBOR didn’t reflect true borrowing costs, BAA has reviewed the methodology of calculating LIBOR.
Benchmark Rates in India:
In India, given the paucity of rates that satisfy the above criterion, not many benchmarks exist, save the MIBOR announced by either NSE or Reuters. NSE has developed and launched the NSE Mumbai Inter-Bank Bid Rate (MIBID) and the NSE Mumbai Inter-Bank Offer Rate (MIBOR) for the overnight money market on June 15, 1998.
The success of the overnight NSE MIBID and MIBOR encouraged the Exchange to develop a benchmark rate for the term money market. NSE launched the 14-day NSE MIBID/MIBOR on November 10, 1998 and the longer term money market benchmark rates for 1 month and 3 months on December 1, 1998.
The NSE MIBID/MIBOR rate is used as a benchmark rate for majority of deals struck for Interest rate swaps, Forward rate agreements (FRAs), Floating rate debentures and Term deposits. Fixed Income Money Market and Derivative Association of India (FIMMDA) has been in the forefront for creation of benchmarks that can be used by the market participants to bring uniformity in the market place.
To take the process of development further, FIMMDA and NSE have taken the initiative to co-brand the dissemination of reference rates for the overnight call and term money market using the current methodology behind NSE MIBID/MIBOR. The product was therefore rechristened as ‘FIMMDA-NSE MIBID/MIBOR.