Fundamental Financial Concept: Reference Rate

Definition of Reference rate

Reference rate is defined by the interest rate which is reliant on a floating-rate security or interest rate swap. A reference rate which, is dedicated to determine payoffs in finance related contract, not under the control of involved parties in the contract. The reference rate can take the form of moving index such as LIBOR, the prime rate or the rate on benchmark U.S. Treasuries.

• Reference rate is not limited in one, can take many forms, reference rate can take the form of an inflation benchmark (such as the Consumer Price Index) or a measure of economic health (such as unemployment rates or corporate default rates) depending on the written financial contract or security.

• Reference rate is a standard, which is implemented to determine the interest rate of other financial transactions, mortgages and floating rate securities, is used as a benchmark rate with additional fixed amounts with additional individual contracts.

Books on Reference rate

Book 1:

Floating-Rate Securities By Frank J. Fabozzi, CFA, Steven V. Mann (published by John Wiley & Sons, 2000)

Book 2:

Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option By John Williamson (published by Peterson Institute, 2000)

How Reference rate works?

• Mostly, reference rate is enforced on short-term interest rate such as LIBOR, such as loans, floating rate notes, short-term interest rate futures contracts, swaps, etc. The calculations of interest are done by autonomous organization like the British Bankers Association (BBA) in order to entail the independence the average of rates are quoted by large panel of banks.

• Constant maturity swaps are another form of examples regarding reference rate; independent organizations use the ISDAfix rates for daily calculations, the International Swaps and Derivatives Association, quotes decided by a large panel of banks.

• The same concept of the reference rate is used in the credit derivative market, where the pay-offs the decided by the rates but positive events.

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