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Reference Asset

Updated on January 5, 2024
Article byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Reference Asset?

Reference assets are underlying assets used as a backup for a contingent payment in market or credit risk cases. They are typically high-rated sovereign debt instruments or equity index prices. They are also known as reference entities or reference obligations.

Reference Asset

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Reference assets, especially in cases of investments, are essential in risk and portfolio management. Traders and investors use derivatives to hedge their holdings or make predictions about the course of the reference asset’s price. Investors can reduce possible losses or increase returns by placing positions in derivatives connected to their current holdings.

Key Takeaways

  • A reference asset is an underlying asset used in credit derivatives to shield a debt holder from a high-risk borrower.
  • These assets could be some unrelated asset, a stock index, or the stock of another company.
  • The asset serves as a standard or foundation for figuring out financial products’ worth, cost, or efficiency. It links the derivative and the linked asset’s intrinsic value.
  • It enables accurate pricing of derivatives and helps manage risk through inverse correlation. They provide transparency, facilitate risk management, enhance market activity, and contribute to market efficiency and investor confidence.

Reference Asset Explained

A reference asset signifies debt that underlies a credit derivative and protects a debt holder from a high-risk borrower. A derivative is a financial agreement whose worth is based on the value of underlying reference assets, rates, or indices. These assets could be some unrelated asset, a stock index, or the stock of another company. The asset is a crucial part of many derivatives and financial products. It creates a connection between the derivative and the performance or underlying value of the particular asset. Market players can appropriately price derivatives and control risk through this.

The asset serves as a standard or foundation for figuring out financial products’ worth, cost, or efficiency. In addition, they help in avoiding default risk. The default risk is the risk an entity faces when it issues debt or borrows money with due repayments. It is inherent to the debt holder as the borrower may have a high chance of debt defaults. The debt holder can enter a credit derivative, such as a credit default swap (CDS) instrument or a total return, to hedge against this risk.

Credit derivatives, such as the CDS, are underlying assets used as reference bases to protect debt holders from credit risks associated with a borrower. These assets also include bonds, broadly fixed-income securities or notes, and debt-backed securities. These are used to calculate payments under a credit derivative contract. They protect debt holders from the risks of borrowers defaulting on debts. The debt holders purchase these credit derivatives to transfer this risk to a third party, allowing them to receive the reference asset if the borrower defaults on the debt. They may be entitled to receive all or the partial value of the debt. It ensures protection against default risks.

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Examples

Let us look at a few examples to gain a better understanding of the concept.

Example #1

Let us look at the example of an imaginary investor who uses a credit default swap reference asset.

Dan is a bond investor who is experienced and has exposure to a portfolio of corporate bonds. Dan enters into a credit default swap (CDS) with a financial institution, ABC Bank, to manage his credit risk.

He agrees to make regular payments to ABC banks in exchange for protection against such risks. Therefore, Dan and ABC Bank agree on the terms of the CDS contract. They determine that the reference asset will be a $10 million bond issued by Company XYZ, with a maturity of five years.

The reference or underlying asset for this credit default swap reference asset is a specific corporate bond issued by Company XYZ. Dan receives compensation from ABC Bank in case of a credit event, such as default or bankruptcy. The compensation he gets is based on the difference between the bond’s face value and the market price at the time of the event.

Dan and ABC Bank closely monitor Company XYZ’s creditworthiness and the reference asset’s performance throughout the CDS’s life. If the bond matures without any credit event, the CDS ends, and Dan’s protection ceases. If a credit event occurs, the CDS terminates, and Dan receives compensation from ABC Bank based on the agreed-upon terms.

In this hypothetical example, Dan uses a credit default swap as a risk management tool to protect himself against the credit risk associated with a specific corporate bond (the reference asset). The CDS allows Dan to transfer the risk of default to ABC Bank in exchange for premium payments. Dan receives compensation to offset his potential losses if a credit event occurs.

Example #2

Let us consider the imaginary example of Sarah, who uses a total return swap reference asset strategy.

Sarah, an investor, wants to purchase a seven-year-old BAA-rated bond. It is issued by XYZ Ltd. She wants to avoid buying the bond or taking delivery. Supposing a bank called ABC owns the same bond and offers to extend a loan to XYZ Ltd., its investors in debt instruments have exhausted their capacity to lend to XYZ Ltd.

In such a case, the total return swap reference asset strategy would allow Sarah to receive full economic returns without buying them. An obligation representing the total return on a reference underlying asset or index is swapped in a total return swap. The swap is done for an obligation with an interest obligation based on a fixed or floating interest rate. The bank can reduce its risk exposure to XYZ Corporation by entering a total return swap. In this arrangement, the bank would have sold the bond without having to sell it. Through this, Sarah can also cut her long 5-year period short based on the bond’s total return stream.

Example #3

The U.S Securities Exchange Commission (SEC) released a document about a particular Note called buffered accelerated market participation securities linked to the S&P 500 index.

The buffered accelerated securities (notes) are the derivative, and the S&P 500 is the reference asset. The bank that deals with it is HSBC USA Inc., which becomes the agent that purchases the notes from the SEC for distribution among registered brokers and dealers or to offer them to investors directly.

The price at which it is made available to the public is $1000 per note. In this case, it states that there will be a limit of 24.90% on the maximum returns, which will be determined on the trade date as per its exposure (2 times) to any positive returns to the referenced asset.

The maturity provided in this case is 2.5 years. Protection is also provided for the first 10% loss of the referenced asset; if the referenced asset declines, the investor will lose 1% of their investment for every 1% decline beyond the buffer percentage. However, they are not FDIC-insured or bank-guaranteed and may lose value and not bear interest.

Benefits

Some of the potential benefits attained through reference underlying assets are:

  • Financial institutions utilize credit derivatives to manage risk by enabling investors to hedge their positions and lessen potential losses.
  • Payments can be made to the holder under a credit derivative contract if the issuer defaults and fails to make payments on them.
  • Credit derivatives trading increases market activity; however, it can also make the market exceedingly complicated.
  • Risk can be directly hedged via derivatives and can be used to trade both credit and risk.
  • Investors can comprehend the fundamental factors that determine the value and performance of financial products due to their transparency and uniformity.
  • It supports market efficiency and investor confidence by encouraging price discovery and assisting in capital allocation.

Frequently Asked Questions (FAQs)

1. How are credit-linked notes (CLN) related to reference assets?

CLN (Credit-linked notes) are debt securities backed by referenced assets with an embedded credit default swap (CDS). It transfers credit risk from the issuer to investors. Repayment depends on the underlying asset performance, with total redemption value paid at maturity minus default losses. CDS is an integral part of the bond.

2. Is there any risk associated with reference assets?

Yes, there are risks associated with reference assets. The asset’s value or performance can fluctuate, impacting the value of derivative contracts or financial products linked to it. Market volatility, economic conditions, and other factors can affect the asset’s price, leading to potential losses for investors.

3. What is the reference asset on a TRS trade can be?

A Total Return Swap (TRS) trade involves a reference or underlying asset, such as a bond, commodity, or equity index. It is determined by the asset’s price movements, reflecting the asset’s total return, including dividends, interest, and capital appreciation, depending on the specific agreement between the parties.

This article has been a guide to what is a Reference Asset. Here, we explain the concept in detail with its examples and benefits. You may also find some useful articles here –

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