Reference Rate

AAA

DEFINITION of '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).

INVESTOPEDIA EXPLAINS '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

    LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate ...
  2. Floating-Rate Note - FRN

    A note with a variable interest rate. The interest rate is usually ...
  3. Reset Margin

    The difference between the interest rate of a security and the ...
  4. Personal Finance

    All financial decisions and activities of an individual, this ...
  5. Interest Rate Swap

    An agreement between two parties (known as counterparties) where ...
  6. Prime Rate

    The interest rate that commercial banks charge their most credit-worthy ...
RELATED FAQS
  1. What is the difference between a 2/28 and a 3/27 ARM?

    An adjustable rate mortgage (ARM) is a type of mortgage that has a fixed interest rate for a certain time period at the beginning ... Read Full Answer >>
  2. What is the difference between consumer surplus and economic surplus?

    The consumer surplus is the difference between the highest price a consumer is willing to pay and the actual market price ... Read Full Answer >>
  3. What does it signify about a given product if the consumer surplus figure for that ...

    High consumer surplus for a particular product signifies a high level of utility for consumers and may carry some implications ... Read Full Answer >>
  4. How is the risk-free rate of interest used to calculate other types of interest rates ...

    The risk-free rate for bonds is used for pricing the yield spread as the difference between the interest rate on a bond and ... Read Full Answer >>
  5. How does the balance of trade impact currency exchange rates?

    The balance of trade influences currency exchange rates through its effect on the supply and demand for foreign exchange. ... Read Full Answer >>
  6. How do interest rates impact risk aversion in the market?

    Interest rates entice savers and lenders to assume risk, allocate resources across time and affect the cost of entrepreneurial ... Read Full Answer >>
Related Articles
  1. Options & Futures

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  2. Home & Auto

    Option ARMs: American Dream Or Mortgage Nightmare?

    Option adjustable rate mortgages could make or break your home-buying experience.
  3. Economics

    What is a Capital Account?

    Capital account is an economic term that refers to the net change in investment and asset ownership for a nation.
  4. Economics

    Understanding the Fisher Effect

    The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.
  5. Investing

    Three Portfolio Moves To Consider Now

    What portfolio moves should you consider making as the 2nd quarter kicks off? Before we focus on the future, let’s first reflect on the 1st Q surprises.
  6. Investing

    The Labor Market Recovery’s Missing Ingredient

    Job creation is running at the fastest pace since the 90s, and there is some evidence that wage growth is finally starting to accelerate, albeit modestly.
  7. Economics

    Gambling on Macau: Too Risky?

    Macau was once heralded as the new Las Vegas for casino investors. Is it too late?
  8. Investing

    Pockets Of Value In The Stock Market

    U.S. stocks benefited from signs the Fed’s path toward higher interest rates, as well as from continued merger-and-acquisition activity on of low rates.
  9. Economics

    When To Expect Fed Liftoff Now

    “When will the Fed raise interest rates?” That has been the question of many investors since the Fed indicated it was prepared to end its zero rate policy.
  10. Active Trading Fundamentals

    Where And How Should You Make Your First Trade?

    New traders should enter markets that offer the greatest opportunity for learning their craft while keeping risk at a minimum.

You May Also Like

Hot Definitions
  1. Fixed-Income Arbitrage

    An investment strategy that attempts to profit from arbitrage opportunities in interest rate securities. When using a fixed-income ...
  2. Venture-Capital-Backed IPO

    The selling to the public of shares in a company that has previously been funded primarily by private investors. The alternative ...
  3. Merger Arbitrage

    A hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless ...
  4. Market Failure

    An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers ...
  5. Unsystematic Risk

    Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through ...
  6. Security Market Line - SML

    A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky ...
Trading Center