What is Reference Asset
A reference asset is an underlying asset used in credit derivatives to protect a debt holder against a potentially risky borrower. A reference asset is also known as a reference entity, a reference obligation or a covered obligation. A reference asset can be an asset such as a bond, note or other debt-backed security.
BREAKING DOWN Reference Asset
A reference asset is a type of debt-backed security. When an entity issues debt or borrows money, there is always a chance that it will not repay the funds, which is called the default risk. The debt holder is inherently exposed to risk by the possibility of the borrower defaulting on the debt. To hedge against this default risk, the debt holder may enter into a credit derivative, such as a total return or a credit default swap (CDS). These credit derivatives assign the risk to a third party against the risk of default.
A credit default swap (CDS), which is the most commonly used type of credit derivative, allows the debt holder to transfer the risk they are exposed to onto a third party, which is usually another lender. Using this method, they may assign the risk without selling the asset itself. The debt holder will pay a one-time or an ongoing fee, referred to as a premium, to the third party. If the borrower should default on the debt, the debt holder is entitled to a portion of the reference asset.
Example of a Credit Default Swap (CDS) Reference Asset
Reference assets in a credit default swap, which can also be referred to as a credit derivative contract, commonly consist of assets like municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds, issued by the borrower or reference entity.
Bank A invests in a bond from Corporation X, despite Corporation X’s reputation as a risky borrower. To protect itself against the risk of Corporation X defaulting on the bond, Bank A decides to engage in a credit default swap (CDS) with Bank B. Under the CDS, Bank A will pay a premium to Bank B for assuming some risk. However, Bank A still officially owns the Corporation X bond. If Corporation X should default on the bond, Bank A will then receive a portion, or all of, the value of the original bond, the reference asset, from Bank B. If Corporation X ends up not defaulting on the loan, Bank B makes a profit from the premium paid by Bank A in exchange for the risk it took on.