What is a reference asset?
Reference assets are underlying assets used in credit derivatives to protect debtors from potentially risky borrowers. Reference assets are also known as reference entities, reference obligations, or covered bonds. Reference assets can be assets such as bonds, bills, or other debt-backed securities.
- Reference assets are underlying assets used in credit derivatives to protect debtors from potentially risky borrowers.
- When a company issues debt or borrows money, it is always possible that it will not repay the money. To protect against this default risk, debtors may enter into credit derivatives such as total returns and credit default swaps (CDS).
- These credit derivatives assign risk to a third party against the default risk.
How reference assets work
Reference assets are a type of debt-backed security. When a company issues debt or borrows money, it is always possible that it will not repay the funds called default risk. Debtors are inherently at risk because the borrower can default. To hedge this default risk, the debtor may enter into credit derivatives such as total returns and credit default swaps (CDS). These credit derivatives assign risk to a third party against the default risk.
Credit default swaps (CDS), the most commonly used type of credit derivative, allow debtors to transfer the risk they are exposed to to a third party, usually another lender. increase. This method allows you to allocate risk without selling the asset itself. The debtor pays a third party a one-time or ongoing fee called a premium. If the borrower defaults, the debtor is entitled to a portion of the reference asset.
Reference asset example
Credit Default Swap (CDS)
Credit default swap (CDS) reference assets, also known as credit derivative contracts, typically consist of assets such as municipal bonds, emerging market bonds, mortgage-backed securities (MBS), or corporate bonds. Borrower or reference entity.
For example, suppose Bank A invests in a bond from Company X, despite Company X’s reputation as a high-risk borrower. To protect itself from the risk of corporate X defaulting on bonds, bank A decides to make a credit default swap (CDS) with bank B. Under the CDS, Bank A pays Bank B a premium to take on any risk. However, Bank A still officially owns Corporation X bonds. If Company X defaults on the bond, Bank A receives some or all of the value of the original bond (reference asset) from Bank B. If Company X did not default the loan, Bank B would benefit from the premium paid by Bank A in exchange for the risk assumed by Bank A.