A reference entity is the subject of a Credit Default Swap (CDS), a financial product used in speculation, arbitrage, and hedging. In a CDS, a seller offers protection for a buyer concerned about the possibility that the reference entity will default. The entity is not a party to the transaction and may not even be aware that it has taken place. Buyers and sellers alike use the CDS as a tool for managing risk, distributing investments, and making bets on the market. This financial instrument is less regulated than options like insurance, and can come with higher profits for those who know how to use it effectively.
Governments and companies are usually reference entities. They issue debts like bonds to finance activities and run a risk of defaulting, which can vary depending on their credit rating, the current market conditions, and other factors. Buyers of debt instruments make a calculated assessment before a purchase to decide if they think it will be a safe investment. In addition, they can opt to use a CDS to transfer the risk to the seller of the swap, rather than retaining it.
Sellers of credit default swaps identify a reference entity of interest and determine the risk of default when deciding on an offering price. In addition to offering products to people who hold debt obligations associated with the reference entity, they can offer what are known as naked credit default swaps. Buyers in such transactions don’t actually hold any debt, but use the swap as a speculative tool, betting on whether a company or government is likely to default.
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Specific financial events are identified in the contract to determine when the credit default swap will pay out. If the reference entity does default, the buyer may be able to trade in the debt for the par value, or can receive a cash settlement from the seller. This allows investors to consider several options when deciding how they want to manage risk. Other investors may see a CDS as an opportunity for profiting without directly holding any debt instruments.
Credit default swaps were originally developed as a risk management tool. A reference entity could be seen as a safer investment if a CDS could be used to hedge risk. Over time, they became investment entities in their own right, rather than a tool to accompany investments. The lightly regulated trade in credit default swaps was fingered as one of the possible causes of the global financial tumult that occurred in the early 21st century.