What Is a Reference Obligation?
A reference obligation is a specially designated debt obligation upon which a credit derivative, such as a credit default swap, is based and is issued by the reference entity. It does not represent all the forms of debt issued by the entity, but only a specific obligation. Often, this obligation is the actual debt security that the credit derivative was created to hedge.
Understanding Reference Obligation
The reference obligation is the specific issue of a debt security upon which the two parties in the credit derivative transaction are betting against each other. For example, the 5-year bond of a company, bank or country. If the reference entity defaults on this issue (or another specific, agreed-upon event occurs), the buyer of the credit protection on the reference obligation receives a payout. The protection buyer receives compensation for the fact that the entity has failed to make a payment on the reference obligation. If no triggering (default) event occurs to the reference obligation, the seller of the credit derivative profits from the premium paid by the buyer. Much like an insurance product where the insurance company keeps the premium paid by a policyholder if 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 designed to transfer the credit exposure of a referenced obligation in the swap between two or more 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. Often 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 basic mechanics of a CDS instrument. The person buying credit protection receives a payout if there is a credit event on the reference obligation. If nothing happens related to the reference obligation, the CDS seller keeps the premium.
It is essential to specify the reference obligation since ambiguity can lead to enforcement problems in the event of default. For example, when buying credit protection on a specific bond issued by a company or bank, it is vital to identify the reference obligation correctly. This is usually done by referring to its ISIN number. Doing this prevents any confusion about the maturity, coupon or currency of the issued bond.