What it means
A credit default swap is a contract in which one party pays a regular fee to another party in return for compensation if a borrower fails to pay its debts. The borrower is called the reference entity.
The reference obligation is the particular loan or bond that anchors the contract and tells everyone what kind of debt is being covered. Naming a specific obligation matters because a company can have many kinds of debt.
Some are senior, meaning they are repaid first in a failure, and others are subordinated, meaning they sit lower in the queue. A reference obligation fixes the ranking that the contract refers to, which prevents argument later.
The reference obligation also helps to decide what can be delivered or valued after a credit event, such as a failure to pay or a bankruptcy. Under many contracts, the protection buyer can hand over any obligation that is of the same rank as the reference obligation, or the payout is calculated from the market price of such debt.
This is why the choice of obligation is part of the pricing of the swap. For a non-specialist, the practical point is that the contract does not insure the company in general but a defined layer of its debt.
If the company later restructures or replaces the named bond, the contract has rules for substituting a new reference obligation. Those rules are part of the standard documentation and worth reading in any dispute.
Regulation and market practice changed the form of these contracts over the years, so details vary from one market to another. The core idea is stable, though, since the buyer of protection and the seller must agree precisely what debt is being insured.
Without that agreement, the swap would invite endless disputes after a default. For a bank risk manager, the reference obligation is also a test of whether a hedge really hedges.
If the bank's own loan ranks differently from the named bond, a default may pay out more or less than the bank actually loses. That gap is called basis risk, and a careful reviewer looks for it first.
In practice
Real-world examples.
Example
A bank has lent $20,000,000 to a manufacturer and buys credit protection through a swap. The contract names the manufacturer's senior unsecured bond as the reference obligation, so the bank knows exactly which ranking of debt determines its payout.
Example
A hedge fund sells protection on a retailer and reads the confirmation carefully. It finds that the reference obligation is a subordinated bond, which it expects to lose more value in a default, and it asks for a higher fee to compensate for that risk.
Example
A company restructures and its named bond is repaid early. The swap's rules allow the two parties to substitute a successor bond as the new reference obligation, and the contract continues without needing to be rewritten.
Formula
Calculation
Payout on a credit event = notional amount x (1 - recovery rate)
Suppose a bank buys protection on $10,000,000 of a company's senior bonds, and the company defaults. The market price of the reference obligation after the default indicates that holders recover 40 cents on the dollar, so the recovery rate is 40%. Payout = 10,000,000 x (1 - 0.40) = 10,000,000 x 0.60 = $6,000,000. The bank absorbs the other $4,000,000 as its own recovery loss, which is why the payout formula uses the loss given default and not the full notional amount.Case study
Seen in the real world.
Greyfell Credit Partners is an illustrative, fictional fund that sold protection on a mid-sized airline. The fund believed the airline was solid and was glad to collect the regular fee.
When the airline later filed for bankruptcy, the fund discovered that the reference obligation was a senior bond that recovered 45 cents on the dollar. On a $5,000,000 position the fund owed 5,000,000 x 0.55 = $2,750,000 to the buyer of protection.
The fund had modelled a lower payout because it had assumed that the reference obligation was a subordinated bond. The illustrative lesson is that the exact wording of the contract determines the loss, and the reference obligation is one of the first lines to read. After the episode, the fund's risk committee required a one-page summary of the reference obligation, its ranking and its likely recovery before any new swap was approved.
Watch out
Common mistakes.
- Believing that a credit default swap covers all of a company's debts, when it refers to a defined type and ranking of debt.
- Ignoring the ranking of the reference obligation, which strongly affects the recovery and therefore the payout.
- Assuming the reference obligation never changes, when substitution rules apply after a restructuring or repayment.
Questions
People also ask.
What is the difference between the reference entity and the reference obligation?
The reference entity is the borrower being insured, and the reference obligation is the specific debt that anchors the contract.
Does the protection buyer need to own the reference obligation?
Not necessarily, since many contracts allow protection to be bought without holding the debt, though the buyer then faces a different risk profile.
Where do I find it?
It is listed in the swap confirmation, usually alongside the notional amount, the maturity date and the list of credit events. A risk manager should read it before looking at the price.
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