What is a 'Reference Rate'

An interest rate benchmark upon which a floating-rate security or interest rate swap is based. The reference rate will be a moving index such as LIBOR, the prime rate or the rate on benchmark U.S. Treasuries.

Depending on the security or financial contract being written, the reference rate can be more esoteric, in 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).

BREAKING DOWN 'Reference Rate'

Reference rates are at the core of an adjustable rate mortgage (ARM), where the borrower's interest rate will be the reference rate (usually LIBOR) plus a fixed amount, known as the spread. From the point of view of a lender, the reference rate is a guaranteed rate of borrowing, so at minimum the lender always earns the spread as profit.

If the reference rate makes a sudden move upward, borrowers who must pay floating interest rates will see their payments rise dramatically.

When used in an interest rate swap, the floating reference rate is exchanged by one party to the transaction for a fixed interest rate or set of payments.

RELATED TERMS
  1. Interest Rate Swap

    An agreement between two parties (known as counterparties) where ...
  2. Swap Rate

    The rate of the fixed portion of a swap as determined by its ...
  3. Interest Rate Index

    An index that is based on the interest rate of a financial instrument ...
  4. Floating Interest Rate

    An interest rate that is allowed to move up and down with the ...
  5. Variable Interest Rate

    A variable interest rate is an interest rate on a loan or security ...
  6. Accrual Swap

    A form of discrete time-switch option in which the interest on ...
Related Articles
  1. Insights

    Who Uses Libor Data And Why?

    LIBOR is a crucial benchmark reference rate with global economic impact.
  2. Trading

    Managing Interest Rate Risk

    Interest rate risk stems from the possibility that an interest-bearing asset’s value will change due to changing interest rates.
  3. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  4. Trading

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  5. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  6. Managing Wealth

    Managing Interest Rate Risk

    Learn which tools you need to manage the risk that comes with changing rates.
  7. Trading

    Interest Rate Swaps Explained

    Plain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows.
  8. Personal Finance

    How Interest Rate Cuts Affect Consumers

    Traders rejoice when the Fed drops the rate, but is it good news for all? Find out here.
  9. Personal Finance

    Adjustable-Rate Mortgage Indexes: Know Your Benchmark

    Understanding these benchmarks can help you select the most competitive adjustable-rate loan.
  10. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
RELATED FAQS
  1. Can individual investors profit from interest rate swaps?

    Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate ... Read Answer >>
  2. What are interest rate swaps on the OTC market?

    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
  3. How does LIBOR compare to the Federal Reserve rate as an accurate indicator?

    Explore a comparison of the predictive efficacy of the Federal Reserve's fed funds rate and the Intercontinental Exchange's ... Read Answer >>
  4. How can an investor reduce interest rate risk?

    Learn about the different ways investors can reduce interest rate risk. Locking in interest rates increases certainty for ... Read Answer >>
  5. How do companies benefit from interest rate and currency swaps?

    An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular ... Read Answer >>
Hot Definitions
  1. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends each year relative to its share price.
  2. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. ...
  3. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  4. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  5. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
  6. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
Trading Center