What Is a Reference Equity?
A reference equity refers to the underlying equity that an investor is seeking price movement protection for in a derivatives transaction. Reference equities are most commonly associated with equity or credit default swaps as well as put options. Most options that are purchased to protect against price drops in a reference equity are deeply out of the money, initially.
- In trading, a reference equity is the underlying stock that protection has been purchased for.
- This protection can be in the form of a put option, or else an equity default or credit default swap.
- Protection is purchased on a reference equity to stem potential losses from a large downside price movement.
Understanding Reference Equity
Investors use a variety of derivatives to protect themselves from security price changes to the downside, including the default of a company. There are several ways to do this, including swaps and buying put options.
The reference equity is that upon which the derivative’s price is based (a derivative is a financial instrument with a price that is based on a different asset). A put option is a contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a pre-determined price within a specified time frame. The specified price the put option buyer can sell at is called the strike price. If an investor has a sizable long position in XYZ stock, they can purchase a protective put that guarantees the investor will not lose any further money below the option's strike price. The protective put sets a known floor price below which the investor will not continue to lose any added money even as the underlying asset's price continues to fall and the reference equity would be XYZ stock.
Equity Default Swaps
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.