Reference rate

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A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate. Parties to the contract choose a reference rate that neither party has power to manipulate.

[edit] Examples of use

The most common use of reference rates is that of short term interest rates such as LIBOR in floating rate notes, loans, swaps, short term interest rate futures contracts, etc. The rates are calculated by an independent organisation, such as the British Bankers Association (BBA) as the average of the rates quoted by a large panel of banks, to ensure independence.

Another example is that of swap reference rates for constant maturity swaps. The rate that is used is calculated daily by an independent organisation, the International Swaps and Derivatives Association, from quotes from a large panel of banks.

In the credit derivative market a similar concept to reference rates is used. Pay offs are not determined by a rate, but by possible events. In this case, the reference event has to be a very precisely defined credit event, to make sure there can be no disagreement on whether the event has occurred or not.

Typically the benchmark LIBOR is the three-month rate.