Reference Entity: What It Is, How It Works

What Is Reference Entity?

A reference entity is the issuer of the debt that underlies a credit derivative. The reference entity is the organization that issued the reference asset (bond or other debt-backed security) that, in turn, is the subject of a credit derivative. The reference entity can be a corporation, government, or other legal entity that issues debt of any kind. In many cases, the credit derivative that names a reference entity is a credit default swap (CDS).

If a credit event such as a default occurs and the reference entity is unable to satisfy the conditions of the loan, the buyer of the credit default swap receives payment from the seller of the CDS.

Understanding a Reference Entity

The reference entity is essentially the party upon which the two counterparties in a credit derivative transaction are speculating. The seller of a credit default swap (CDS) is betting that the underlying debt issue (known as the reference asset) and the company or government (reference entity) will be able to fulfill its obligations without any trouble.

The purchaser of a credit default swap is either insuring their investment in the reference entity's debt or speculating on the condition of the reference entity without actually holding the underlying asset. A buyer can purchase a CDS to offset risk in various types of underlying assets, such as corporate bonds, municipal bonds, and mortgage-backed securities (MBS).

Reference Entities and Insurance

In theory, a credit default swap contract is insurance on the default risk posed by the reference entity. In return for a fee, the seller of the transaction is selling protection against the default of the reference entity. The buyer of the credit derivative believes that there may be a chance that the reference entity will default upon their issued debt and is therefore entering the appropriate position.

This is a simple hedge, or insurance, where the owner of the reference entity debt is paying so that, in the case of default, the seller of the CDS will make them whole according to the original terms of the investment. If nothing happens, the owner of the debt has paid a price for the peace of mind that the CDS brings. If a credit event occurs, the seller of the CDS takes a hit in paying out the difference to the buyer of the CDS. 

Reference Entities and Speculation

In practice, the CDS market is much larger than the reference assets for which it sells protection. This means that speculators are taking out credit default swaps without actually owning the underlying debts or debt-backed securities. In this case, the CDS becomes a speculative tool where the seller and the buyer bet against each other on the chances of a credit event happening to a particular reference entity.

This saves the speculator the trouble of shorting the stock, or the seller the capital investment of buying bonds for the long term. They can simply enter a contract that will cost the speculator a periodic fee if the reference entity doesn't run into trouble, and will pay out handsomely if the reference entity suffers a credit event. On top of all this, the CDS itself is a tradable instrument, introducing the element of timing rather than simply holding a contract until expiration.