Reference Entity
What Is Reference Entity?
A reference entity is the issuer of the debt that underlies a credit derivative. The reference entity is the organization that issued the reference asset (bond or other debt-backed security) that, thusly, is the subject of a credit derivative. The reference entity can be a corporation, government, or other legal entity that issues debt of any sort. Generally speaking, the credit derivative that names a reference entity is a credit default swap (CDS).
On the off chance that a [credit event](/credit-event, for example, a default happens and the reference entity is unable to fulfill the conditions of the loan, the buyer of the credit default swap gets payment from the seller of the CDS.
Figuring out a Reference Entity
The reference entity is basically the party whereupon the two counterparties in a credit derivative transaction are guessing. The seller of a credit default swap (CDS) is betting that the underlying debt issue (known as the reference asset) and the company or government (reference entity) will actually want to satisfy its obligations easily.
The purchaser of a credit default swap is either safeguarding their investment in the reference entity's debt or conjecturing on the condition of the reference entity without really holding the underlying asset. A buyer can purchase a CDS to offset risk in different types of underlying assets, like corporate bonds, municipal bonds, and mortgage-backed securities (MBS).
Reference Entities and Insurance
In theory, a credit default swap contract is insurance on the default risk presented by the reference entity. In return for a fee, the seller of the transaction is selling protection against the default of the reference entity. The buyer of the credit derivative accepts that there might be a chance that the reference entity will default upon their issued debt and is subsequently entering the suitable position.
This is a simple hedge, or insurance, where the owner of the reference entity debt is paying so that, on account of default, the seller of the CDS will restore them as per the original terms of the investment. In the case of nothing occurs, the owner of the debt has paid a price for the peace of brain that the CDS brings. On the off chance that a credit event happens, the seller of the CDS endures a shot in paying out the difference to the buyer of the CDS.
The three most common types of credit events that could make a seller of a CDS pay the buyer are bankruptcy, payment default, and debt restructuring.
Reference Entities and Speculation
In practice, the CDS market is a lot bigger than the reference assets for which it sells protection. This means that speculators are assuming out praise default swaps without really claiming the underlying debts or debt-backed securities. In this case, the CDS turns into a speculative device where the seller and the buyer bet against one another on the chances of a credit event happening to a specific reference entity.
This saves the speculator the difficulty of shorting the stock, or the seller the capital investment of buying bonds as long as possible. They can essentially enter a contract that will cost the speculator a periodic fee in the event that the reference entity doesn't run into inconvenience, and will pay out liberally assuming the reference entity experiences a credit event. On top of this, the CDS itself is a tradable instrument, presenting the element of timing as opposed to just holding a contract until expiration.
Features
- A reference entity is the issuer of the debt that underlies a credit derivative.
- Like an insurance policy, a CDS requires the buyer to pay the seller a continuous premium to keep up with the contract.
- In the event that a credit event (like a default or bankruptcy) happens, the seller of a CDS will pay the buyer the value of the security and the interest payments that would have been paid between the hour of the credit event and the maturity date of the security.
- A reference entity — which can be a corporation, government, or other legal entity that issues debt of any sort — is the party whereupon two counterparties in a credit derivative transaction are hypothesizing.
- A credit default swap (CDS) is a type of credit derivative or financial contract that enables an investor to swap their credit risk with that of another investor.
