Efficiency of the 1 month LIBOR futures market in light of the recent LIBOR setting scandal -

Abstract

This paper examines the relationship between spot and future prices for the 1 month LIBOR market in light of the recent LIBOR setting scandal. In particular, we examine whether 1 month LIBOR futures are (1) an unbiased predictor of future LIBOR spot rates and (2) the predictive ability of LIBOR futures in forecasting future spot rates. Despite the manipulations by prime banks, the 1 month LIBOR futures settlement price closely follows the 1 month LIBOR spot rate. In addition, there is strong statistical evidence that the 1 month LIBOR futures contracts are unbiased predictors of future sport rates. However, the ability of the model to predict future LIBOR spot rates appears to be weak. In part, this failure of 1 month LIBOR futures to predict future spot rates is attributed to the existence of periods of instability or shocks in the financial system. After accounting for such phenomena, the ability of LIBOR futures to predict LIBOR spot rates is greatly enhanced. This leads us to be cautiously optimistic that 1 month LIBOR future could prove to be a useful tool in many financial contexts such as helping the Federal Reserve achieve its target interest rate in the market on hand, and from a regulatory perspective where regulators could rely on the model to spot manipulations in the market on the other hand.