All about reference rate

The Referential Rate was created in the 1990s and is still used as a reference for some investments and financing.

How Does a Reference Rate Work?

Let’s say you want to borrow $5,000 to start a business. Company XYZ offers you a variable interest rate loan at prime plus 5%. That means that the interest rate on the loan equals whatever the prime rate is plus 5%. So if the prime rate is 4%, then your loan carries an interest rate of 9%. The prime rate is the reference rate.

A reference rate is a rate that determines payments in a financial contract and is outside the control of the parties to the contract. It is usually 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. The parties to the contract choose a reference rate that neither party has the power to handle.

Usage examples

The most common use of reference rates is that of short-term interest rates such as LIBOR in floating rate notesloansswaps, 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.

  • Information obtained from Wikipedia, the free encyclopedia and from the investinganswers website

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