The Use of Reference Rates in Financial Markets

Debt securities are widely issued and traded in the secondary market. Debt securities could have a fixed interest rate or a floating interest rate. When debt is taken for the short term, fixed interest rates are preferred. However, in the medium to long run, the interest rates cannot be directly fixed. This is because, as we move farther into the horizon period, economic uncertainty increases even further. As a result, financial markets all over the world have devised a system of reference-based interest rates. In this article, we will have a closer look at what reference rates are and why they are important.

What are Reference Rates?

Reference rates are a type of interest rate. It is actually an intermediate rate which is used to calculate the final rate. Interest rates are defined as the reference rate +/- certain basis points. For instance, if the parties have agreed to pay an interest of reference rate + 500 basis points and the reference rate is 6%, then the applicable interest rate would be 6% + 500 basis points i.e., 6.5%

Why are Reference Rates Important?

As already mentioned above, reference rates are used by financial parties when they draw up a medium to long term financial contract. Reference rates serve several important purposes. Some of them have been listed below:

• It is assumed that reference rates cannot be manipulated by either party. This is important since many times, governments themselves borrow money from the financial markets, and they have the power to change interest rates when they have to repay the loans. However, reference rates are often set by non-government parties. This makes it possible to lend money to the government without the fear that the government has an unfair advantage

• Many times, the reference rates are linked to important parameters such as the unemployment rate or inflation rate. The Treasury Inflation-Protected Securities (TIPS) issued by the United States Treasury is an example of inflation-indexed securities. In such cases, the use of reference rates allows investors to protect themselves from specific negative financial outcomes

• Reference rates allow investors to quantify financial risks and draw up financial contracts. Most swap agreements all over the world are based on some sort of reference rate. When the reference rate reaches a certain level, the cash flows mentioned in the contract change.

• Reference rates allow banks to give loans to subprime customers. Banks generally add certain percentage points to a prime loan rate in order to arrive at a rate that would be applicable to a subprime borrower. It is common for mortgage interest rates to be expressed as a base rate +/- percentage points.

Some Examples of Reference Rates

There are some reference rates which are used in several contracts all over the world. These reference rates are as follows:

1. LIBOR: LIBOR stands for London Interbank Offered Rate. This means that this is the rate at which banks lend to each other. The LIBOR is published by an association of banks. The LIBOR is published for five different currencies, as well as for seven different maturities. Ideally, this rate should only be used by banks for interbank lending. However, this rate is actually used by a wide variety of people for different reasons.

   Most derivative contracts in the world are based on the LIBOR. However, it is not the most reliable interest rate. This is because it is set based upon the bids received by five to six big banks in the London market. Hence, it would be fair to say that LIBOR is open to manipulation.

   In fact, there have been cases registered wherein the LIBOR has been manipulated by bankers. The LIBOR is an offered rate. The LIBID is another rate that is published by the same bankers association. This is a bid rate and is only a few basis points different as compared to the LIBOR rate.

2. EURIBOR: Just like LIBOR is an interbank rate offered by London bankers, the EURIBOR is an interbank rate which is offered by European Bankers. It is important to distinguish between EURIBOR and European LIBOR.

   The European LIBOR is the Euro-denominated LIBOR rate offered by London bankers. The EURIBOR is a recent invention. Prior to that, each country in the Eurozone had its own interbank rate.

   Paris had the PIBOR rate, and Frankfurt had the FIBOR rate. All these rates are now merged into the EURIBOR. The EURIBOR is important since a very large number of derivatives contracts are based on the EURIBOR as well.

There are many reference rates across the world. For instance, Hong Kong has HIBOR, Singapore has SIBOR and Mumbai ha MIBOR. However, these rates are only used locally and do not make much of an impact on the international scene. However, in all cases, the concept remains the same. The reference rates based interest rate system is used in almost all loans across the globe.