May 31, 2011

Thank you, Oprah! Your final show was simply spectacular! It’s hard to believe we’ve tuned in for the last time to see your gripping tales of American lives, or hear the hottest new celebrities share their worldviews, or learn what we should all be reading these days. You taught us so much – about life and love, about laughter and loss, and of course, about LIBOR. That’s right, what you taught us about Eurodollar interbank lending, and about the daily rate fixing on which trillions of dollars in derivative notional is based, is simply priceless. Allow me to share with you some of my favorite lessons from your show, so that everyone can appreciate your work from this very important perspective.

First off, there are a few obvious similarities. Both the Oprah Winfrey Show and USD LIBOR began in 1986, delivering our daily fix of important news and entertainment (the show) and interest rates (LIBOR) that became a part of so many lives. The Oprah Winfrey Show’s producers, sponsors, and even Oprah’s style have changed over the years, but she has maintained the same formula for syndicated-talk-show success throughout. Similarly, contributor banks have come and gone, and the USD panel recently expanded from 16 to 20 banks, but the formula for determining the daily LIBOR fixing remained the same (throw out the highest and lowest quartiles, and average the middle two). And as her empire expanded, with her show becoming one of the longest running daytime talk shows in American history, so too did the market expand for LIBOR, with the number and type of financial instruments indexed to LIBOR increasing year after year. As Oprah’s audience expanded to an average of 40 million TV viewers each week on 212 TV stations throughout the U.S., LIBOR experienced a similar meteoric rise, and is now the benchmark interest rate for some $350 trillion in financial contracts worldwide.

And neither Oprah nor LIBOR have been without controversy. Oprah has had to defend herself against claims of political favoritism in who she decides to interview (think Sarah Palin here), she has dealt with alleged abuse and scandal at the South African school that she funded, and she was very publicly duped in selecting the book “A Million Little Pieces ,” for her book club, only to learn that author James Frey largely fabricated his memoir. So too, the British Banker’s Association (BBA) has had to deal with several USD panel banks providing dubious reference rates, allegedly fabricating the rates at which they could borrow unsecured on tenors ranging from overnight out to 12 months, and thus calling into question the legitimacy of some LIBOR fixings at the time. However, both Oprah and LIBOR survived their critics and remained meaningful.

But perhaps the most important thing that the Oprah taught us is to have the proper perspective when valuing our derivative contracts. Maybe coincidence, maybe not, but we have witnessed a steady decline in LIBOR since back in March when Oprah announced that May 25th would be her final show. Throughout the intervening two months, 1 month LIBOR has hit record daily lows, and rests below 20 basis points as the show ended its 25 year run. It is very easy for viewers to see the latest LIBOR fixing and interpret too much information from this one observable input. For example, many people would believe that their pay-fixed swap or purchased cap contracts must be at their lowest valuations ever, judging from where 1 month LIBOR is today. But this snap assessment neglects the whole string of future rates on which these valuations are based. Swap rates, which are derived from the forward curve, actually hit their lows for various tenors back in October and November of last year.

It turns out that swap rates have little to do with the current observable LIBOR fixing, even if the current period accrual is based on today’s rate. Caps are further contingent on and derive just as much of their value from the volatility of interest rates, which is quite independent of both current LIBOR and forward rates. Just as the value of Oprah Winfrey’s enterprise was never really in just a single show, but lay instead in the possibility of greater entertainment yet to come from her vast media network, so too your derivative valuations have much more to do with future rates than the presently observable fixing (i.e. LIBOR). As the Oprah Winfrey Show ends its long series run, the proper perspective on Oprah and interest rates is therefore to be forward looking, alert for her next endeavor, and mindful of changes in the forward curve that can impact your derivative valuations.

If you have questions about your financial contracts indexed to LIBOR, or on entertainers we all know and love, give us a call! While we can’t promise to follow the next big talk show talent as closely, there is still no bigger fan of the markets than Chatham!