Reference Equity

What Is a Reference Equity?

Reference equity refers to the underlying asset or security that an investor is seeking price movement protection for when they're trading derivatives such as options, equity swaps, or single stock futures.

For instance, with options listed on Microsoft shares, Microsoft (MSFT) would be the reference equity.

Understanding Reference Equity

Reference equity is most commonly associated with equity or credit default swaps as well as with put options. Most options that are purchased to protect against price drops in reference equity are deeply out of the money, initially.

A derivative is a financial instrument with a price that is based on a different underlying asset. The reference equity is that upon which the derivative’s price is based.

Investors use a variety of derivatives to protect themselves from security price changes to the downside, including a company's default on a bond, or corporate bankruptcy. There are several ways to use derivatives, including put options and swaps.

Put Options

A put option is a contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a pre-determined price within a specified time frame. The specified price the put option buyer can sell at is called the strike price.

For example, if an investor has a sizable long position in XYZ stock, they can purchase a protective put. The protective put guarantees they will not lose any money if the stock shares fall below the option's strike price. It sets a known floor price below which the investor will not continue to lose any further money even if the underlying asset's price continues to fall. In this case, the reference equity would be XYZ stock.

Credit Default Swaps

A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset their credit risk with that of another investor. Credit default swaps involve fixed-income debt instruments, like municipal bonds, emerging market bonds, mortgage-backed securities (MBS), or corporate bonds. In this case, the reference equity would be the particular bond or mortgage-backed security.

For example, if a lender is worried that a corporation is going to default on its bonds, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy.

Equity Default Swaps

A relatively new type of option is the equity default swap (EDS) which is designed to provide protection for the investor from price changes to specific reference equity. An EDS is somewhat comparable to a credit default swap (CDS). Only they don't guard against credit risk, as equities do not have the same type of exposure that bonds, mortgages, and other forms of debt do. Instead, equities are exposed to market risk, and an equity default swap is designed to protect against a specific amount of decline in the value of the reference equity.

Reference equities are used in conjunction with a specific equity event when defining the terms of an equity default swap contract, with the terms also including the length of the contract. The reference equity is used by the equity default swap buyer when purchasing a contract from the swap dealer. The option buyer pays a fee or premium to the seller, and the seller agrees to pay the buyer if the value of the reference equity falls.

The amount of money that an EDS buyer receives from the EDS seller is dependent on the terms of the agreement. In some cases, the seller will be required to make a payment proportional to the value of the reference equity after the equity event occurs, while in other cases, the EDS seller will be required to pay a fixed amount. The fixed amount is usually equal to the notional principal amount of the EDS multiplied by a recovery rate.