Reference Asset

What Is a Reference Asset?

A reference asset is an underlying asset utilized in credit derivatives to safeguard a debt holder against a possibly risky borrower. A reference asset is otherwise called a reference entity, a reference obligation, or a covered obligation. A reference asset can be an asset, similar to a bond, note, or other debt-backed security.

How a Reference Asset Works

A reference asset is a type of debt-backed security. At the point when an entity issues debt or gets money, there is consistently a chance that it won't repay the funds, which is called the default risk. The debt holder is innately presented to risk by the possibility of the borrower defaulting on the debt. To hedge against this default risk, the debt holder might go into a credit derivative, for example, a total return or a credit default swap (CDS). These credit derivatives assign the risk to an outsider against the risk of default.

A credit default swap (CDS), which is the most regularly utilized type of credit derivative, permits the debt holder to transfer the risk they are presented to onto an outsider, which is typically another lender. Utilizing this method, they might assign the risk without selling the actual asset. The debt holder will pay a one-time or a continuous fee, alluded to as a premium, to the outsider. In the event that the borrower ought to default on the debt, the debt holder is qualified for a portion of the reference asset.

Illustration of a Reference Asset

Credit Default Swap (CDS)

Reference assets in a credit default swap (CDS), which can likewise be alluded to as a credit derivative contract, generally comprise of assets like municipal bonds, emerging business sector bonds, mortgage-backed securities (MBS), or corporate bonds, issued by the borrower or reference entity.

For instance, assume that Bank A puts resources into a bond from Corporation X, regardless of Corporation X's reputation as a risky borrower. To safeguard itself against the risk of Corporation X defaulting on the bond, Bank A chooses to take part in a credit default swap (CDS) with Bank B. Under the CDS, Bank A will pay a premium to Bank B for expecting some risk. Nonetheless, Bank A still formally possesses the Corporation X bond. On the off chance that Corporation X ought to default on the bond, Bank A will receive a portion, or all of, the value of the original bond (the reference asset) from Bank B. In the event that Corporation X winds up not defaulting on the loan, Bank B creates a gain from the premium paid by Bank An in exchange for the risk it took on.

Features

• At the point when an entity issues debt or gets money, there is generally a chance that it won't repay the funds. To safeguard against this default risk, the debt holder might go into a credit derivative, for example, a total return or a credit default swap (CDS).
• A reference asset is an underlying asset utilized in credit derivatives to safeguard a debt holder against a possibly risky borrower.
• These credit derivatives assign the risk to an outsider against the risk of default.