Reference Rate

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. LIBOR Flat

    An interest rate benchmark used to establish the floating interest ...
  2. Variable Interest Rate

    An interest rate on a loan or security that fluctuates over time, ...
  3. Interest Rate Index

    An index that is based on the interest rate of a financial instrument ...
  4. Accrual Swap

    A form of discrete time-switch option in which the interest on ...
  5. Delayed Rate Setting Swap

    An exchange of cash flows, one of which is based on a fixed interest ...
  6. Floating Interest Rate

    An interest rate that is allowed to move up and down with the ...
Related Articles
  1. Investing Basics

    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.
  2. Options & Futures

    Managing Interest Rate Risk

    Learn which tools you need to manage the risk that comes with changing rates.
  3. Professionals

    Interest Rate and Equity Swaps

    CFA Level 1 - Interest Rate and Equity Swaps. Learn the components of plain vanilla interest rate swaps and equity swaps. Contains sample calculations finding the payments for each swap.
  4. 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.
  5. Investing Basics

    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.
  6. 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
  7. Home & Auto

    Adjustable-Rate Mortgage Indexes: Know Your Benchmark

    Understanding these benchmarks can help you select the most competitive adjustable-rate loan.
  8. Fundamental Analysis

    The Importance Of LIBOR In Financial Markets

    What is LIBOR and why are its interest rates so important to the financial markets?
  9. Credit & Loans

    How Interest Rate Cuts Affect Consumers

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

    London Interbank Offer Rate (LIBOR)

    CFA Level 1 - London Interbank Offer Rate (LIBOR). Learn how banks use the London interbank offer rate when borrowing funds and how this relates to the fixed-income market.
RELATED FAQS
  1. How did the LIBOR scandal affect interest rate swaps?

    Find out how the LIBOR scandal directly enriched some interest rate swap traders and harmed others by understating the real ... Read Answer >>
  2. What is an absolute rate?

    An absolute rate is easy to understand once you know the basics of an interest rate swap. An absolute rate is the fixed rate ... Read Answer >>
  3. 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 >>
  4. 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 >>
  5. 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 >>
  6. 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 >>
Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center