Reference rate

From Academic Kids

A reference rate is any publicly available quoted number or value that is used by the parties to a financial contract. It is often some form of LIBOR index, but can be anything, such as a consumer price index, house prices, unemployment rate.

Independence

A reference rate must be independent and outside the control of either of the parties who reference it, otherwise there will be a conflict of interest. (If either party has the ability to alter the rate, it is safe to assume that they will do so in their favour).

Areas of usage

A recent development of the idea of referencing is in the credit derivative market. Here, the reference value is simply binary, as to whether a specified and well-defined credit event has occurred or not.

ISDA

A recent controversy over the definition of the 1999 ISDA definition of a "restructuring event" called into question the idea of such reference being independent. A restructuring event was triggered in August 2000 when an insurance company restructured about USD 2.8 billion of debt by extending its maturity.

This prompted complaints from protection sellers, who had to compensate (under the 1999 ISDA definition) for an event that was seen as normal in the credit business. There was also a fear of a conflict of interest, since protection buyers had nothing to lose by agreeing to restructuring. (Protection buyers included some of the insurance company's lenders.)

This led to the reference event being redefined by ISDA.

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