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Floating Price Rate
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

Under suggestion advanced by the Secretary of the Treasury in 1982, the PRIME RATE, conventionally defined as the rate which commercial banks charge their highest rates and largest firms for business loans, would float, linked to the rate for COMMERCIAL PAPER.

The suggestion was stimulated by criticism of the prime rate as an indicator of the interest cost of short-term business loans.  A study by the Federal Reserve in May, 1982, had shown that 78.6% of short-term business loans made by large commercial banks were below the prime rate, and of course firms considered to be less creditworthy were paying varying premiums above the posted prime rate.  Commercial paper rates are the reported market rates for primerated commercial paper, whereas the prime rate is an administered rate which is usually changed, on the initiative of one or two of the major banks, with other banks falling in line with the initiated changes.

Changes in the prime rate are usually in response to credit conditions and to developments in the money market and Federal Reserve actions to implement monetary policy, such as fluctuations in the FEDERAL FUNDS effective rate and Federal Reserve DISCOUNT RATE reflecting the direction of OPEN MARKET OPERATIONS and the resulting "tightness" or "ease" in available funds of banks.  Actually, the idea of linking the price rate as a floating rate with commercial paper rates is not new; one of the major banks used to base its prime rate on a moving average of commercial paper rates.  The secretary of the Treasury's suggestion was for the "watch rate" to be the commercial paper rate plus half a percentage point.

Prime Rate Futures.

On December 14, 1981, the CHICAGO BOARD OF TRADWE submitted a proposal for prime rate futures contracts (based on a "benchmark" average of prime rates) to the COMMODITY FUTURES TRADING COMMISSION for approval.  The proposal in turn was announced by the CFTC with request for public comments; as of late in 1982, the proposal was still pending.

Contract trading unit under the CBT proposal would be 1-month $3,000,000 floating price rate loans or multiples thereof.  Beginning with the current contract month, trading months would be set in a 42-month cycle.  Settlement would be in cash, with settlement prices based on a prime rate index calculated by the CBT from prime rates of 10 representative banks selected by the CBT.  At the end of each month, the CBT would calculate the median of the prime rates prevailing each day, and subtract that median from 100 to determine the settlement price for delivery yields.

Because of the volatile behavior of the prime rate in recent years, with many and frequent changes, prime rate futures trading would have appeal, it was felt, for firms borrowing at commercial banks.  However, because of the subjective administered nature of each of the 10 prime rates of the banks, the median used in calculation, and the question of whether a particular borrowing firm would be entitled to points below the prime rate or pay above it, hedges would necessarily be imperfect.

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