Reference Obligation

What Is a Reference Obligation?

A reference obligation is an exceptionally designated debt obligation whereupon a credit derivative, for example, a credit default swap, is based and is issued by the reference entity. It doesn't address every one of the forms of debt issued by the entity, yet just a specific obligation. Frequently, this obligation is the genuine debt security that the credit derivative was made to hedge.

Grasping Reference Obligation

The reference obligation is the specific issue of a debt security whereupon the two parties in the credit derivative transaction are betting against one another. For instance, the 5-year bond of a company, bank or country. On the off chance that the reference entity defaults on this issue (or another specific, settled upon event happens), the buyer of the credit protection on the reference obligation gets a payout. The protection buyer gets compensation for the way that the entity has failed to make a payment on the reference obligation. If no triggering (default) event happens to the reference obligation, the seller of the credit derivative profits from the premium paid by the buyer. Similar as an insurance product where the insurance company keeps the premium paid by a policyholder on the off chance that there is no accident and insurance claim.

A standard form of credit protection on a reference obligation is a credit default swap (CDS), which is a particular type of swap intended to transfer the credit exposure of a referenced obligation in the swap between at least two parties. In a credit default swap, the buyer of the swap makes premium payments to the swap's seller up until the maturity date of a contract. Frequently this is over the period of five years since this maturity is the most common and most liquid part of the credit swap market.

Reference Obligation in Context

This diagram shows the fundamental mechanics of a CDS instrument. The person buying credit protection gets a payout on the off chance that there is a credit event on the reference obligation. Assuming that nothing happens connected with the reference obligation, the CDS seller keeps the premium.

It is essential to determine the reference obligation since equivocalness can lead to enforcement issues in the event of default. For instance, while buying credit protection on a specific bond issued by a company or bank, it is essential to accurately distinguish the reference obligation. This is normally finished by alluding to its ISIN number. Doing this prevents any confusion about the maturity, coupon or currency of the issued bond.