Risk Latte - Who Squared the LIBOR?

Who Squared the LIBOR?

Rahul Bhattacharya
Mar 21, 2005

In the early 1990s, Bankers Trust squared the LIBOR. Before that most people thought only in terms of LIBOR, the short term indicator of interest rates in different currencies.

But the so called "rocket scientists" of the time who remembered their high school algebra a little better than most of the others on Wall Street and Corporate America, got restless and thought of making the lives of corporate treasurers more non-linear. They squared the LIBOR.

The first known LIBOR-squared swap was entered into between Gibson Greetings and Bankers Trust whereby Gibson swapped a fixed rate of interest for a floating rate that depended partially on the square of the LIBOR (London Inter-bank Offered Rate).

LIBOR squared contract (swap, notes, etc.) is a rare derivative. It is both convex and concave and alternates between these two shapes, though when it is struck (at the origin) it is neither. And because the LIBOR is squared it has a gamma and by construction this gamma is sometimes positive and sometimes negative. Actually, this simple act of squaring the LIBOR makes the product extremely complex to manage.

Gibson Greetings apparently lost US$23 million in this transaction.

(Reference: Derivatives for Decision Makers by Bidyut Sen & George Crawford).

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