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Reference Rate

Candlefocus Editor

Reference rates are the benchmark rates that other interest rates are pegged against, a source of commonality that leads to a degree of uniformity in interest rates across various financial instruments. The London interbank offered rate (LIBOR) is the most widely used reference rate; it is calculated by an independent body and is based on the interest rate at which large international banks borrow from each other.

LIBOR is used as a reference rate for various other interest rate agreements and products, including interest rate swaps and adjustable-rate mortgages (ARMs). ARMs typically use the LIBOR as their reference rate, calculating the borrower's interest rate as the prime rate plus a set spread.

Reference rates are also used to determine rates of exchange in foreign exchange markets. When buying foreign currency, the rate that a person pays is the spot reference rate plus a spread, while on the selling side, the rate received is the spot reference rate minus a spread.

Clients may also use a reference rate when giving instructions to their brokers for specific trades. Their instructions may include requests for a trade to be made at an agreed-upon level relative to the reference rate in question.

The reference rate has become increasingly important in the global financial system, due to its role as a base currency for other instruments. With the LIBOR being the most widely used reference rate, ensuring its accuracy and reliability is a top priority. Over the years, however, reports of misconduct related to the setting of LIBOR have emerged, including attempts to manipulate the rate in order to gain an advantage. Such practices have led to tighter regulation of the LIBOR and a broader effort to strengthen the governance and accuracy of the reference rate.

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