What Is a 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, in turn, is the subject of a credit derivative. The reference entity can be a corporation, government, or other legal entity that issues debt of any kind. In many cases, the credit derivative that names a reference entity is a credit default swap (CDS).
- A reference entity is the issuer of the debt that underlies a credit derivative.
- A reference entity—which can be a corporation, government, or other legal entity that issues debt of any kind—is the party upon which two counterparties in a credit derivative transaction are speculating.
- 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.
- Like an insurance policy, a CDS requires the buyer to pay the seller an ongoing premium to maintain the contract.
- If a credit event (such as a default or bankruptcy) occurs, 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 time of the credit event and the maturity date of the security.
Understanding a Reference Entity
The reference entity is essentially the party upon which the two counterparties in a credit derivative transaction are speculating. 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 be able to fulfill its obligations without any trouble.
The purchaser of a credit default swap is either insuring their investment in the reference entity's debt or speculating on the condition of the reference entity without actually holding the underlying asset. A buyer can purchase a CDS to offset risk in various types of underlying assets, such as 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 posed 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 believes that there may be a chance that the reference entity will default upon their issued debt and is therefore entering the appropriate position.
This is a simple hedge, or insurance, where the owner of the reference entity debt is paying so that, in the case of default, the seller of the CDS will make them whole according to the original terms of the investment. If nothing happens, the owner of the debt has paid a price for the peace of mind that the CDS brings. If a credit event occurs, the seller of the CDS takes a hit in paying out the difference to the buyer of the CDS.
The three most common types of credit events that could cause a seller of a CDS to pay the buyer are bankruptcy, payment default, and debt restructuring.
Reference Entities and Speculation
In practice, the CDS market is much larger than the reference assets for which it sells protection. This means that speculators are taking out credit default swaps without actually owning the underlying debts or debt-backed securities. In this case, the CDS becomes a speculative tool where the seller and the buyer bet against each other on the chances of a credit event happening to a particular reference entity.
This saves the speculator the trouble of shorting the stock, or the seller the capital investment of buying bonds for the long term. They can simply enter a contract that will cost the speculator a periodic fee if the reference entity doesn't run into trouble, and will pay out handsomely if the reference entity suffers a credit event. On top of all this, the CDS itself is a tradable instrument, introducing the element of timing rather than simply holding a contract until expiration.