DEFINITION of Reference Equity
The underlying equity that an investor is seeking price movement protection for. Reference equities are most commonly associated with swap options, including equity default swaps and put options. Most options that are purchased to protect against price drops in a reference equity are deeply out of the money initially.
BREAKING DOWN Reference Equity
Investors use a variety of derivatives to protect themselves from security price changes, including the default of a company. A relatively new type of option is the equity default swap (EDS) which is designed to provide protection for the investor from price changes to a specific reference equity. While bonds, mortgages, and similar securities can experience a credit event, such as a default, equities do not have the same type of exposure. Instead, equities are exposed to market risk, and an equity default swap is designed to protect against a specific amount of decline in the value of the reference equity.
Reference equities are used in conjunction with a specific equity event when defining the terms of an equity default swap contract, with the terms also including the term of the contract. This allows the EDS to be comparable to a credit default swap (CDS). The reference equity is used by the equity default swap buyer when purchasing a contract from the swap dealer. The option buyer pays a fee or premium to the seller, and the seller agrees to pay the buyer if the value of the reference equity falls.
The amount of money that an EDS buyer receives from the EDS seller is dependent on the terms of the agreement. In some cases, the seller will be required to make a payment proportional to the value of the reference equity after the equity event occurs, while in other cases, the EDS seller will be required to pay a fixed amount. The fixed amount is usually equal to the notional principal amount of the EDS multiplied by a recovery rate.