A reference asset is the underlying subject of a credit derivative, a financial product based on performance of that asset. Credit derivatives are used by financial firms to control risk; in the event of a credit event like a default, they receive a payment to make good on the transaction. In an example, a company could hold a reference asset like bonds. If the issuer defaults and doesn’t pay out on them, the holder could receive a payment under a credit derivative contract.
Varying types of assets can be used as a reference in such contracts. They may be rated for reliability, which can determine the structure of the contract. The riskier the asset, the more the person holding it may want a credit derivative for protection. Conversely, prospective business partners may be concerned that there will be a high risk of having to pay out because the asset is likely to default.
Derivatives can be used both directly to hedge risk, and to trade in risk and credit. It is possible to sell and trade a derivative while the original holder retains the reference asset. People can make predictions about the asset’s performance and decide whether they want to buy or sell the contract. This creates a complex market that requires constant analysis and careful consideration from investors. If they fall behind on the performance of the reference asset, for example, they could find themselves holding unfavorable derivative contracts.
The original contract should clearly describe the reference asset and provide information about the company that holds it. This allows parties to the contract to assess the level of risk and determine how much the contract should be worth. Future buyers and traders can evaluate this information to determine whether a credit derivative is a sound buy or something that should be avoided. When bonds issued by a company that is about to go under are the underlying asset in a credit derivative, for instance, this information would be important to have.
Trade in credit derivatives allows for increased market activity, but can also create an extremely complex market; advanced traders like institutions and highly experienced individuals tend to be most involved in this type of trading. They have the resources to buy and research underlying assets, study contracts on the market, and make informed choices about purchases. New investors may not have these abilities and could run into trouble on the market.
