Reference entity certificates are products whose basic structure is optimized with the addition of a corporate or government bond (reference bond) with a comparable maturity. This means that, in addition to the issuer risk, the redemption of the product is also subject to the solvency of the reference entity (i.e. the non-occurrence of a credit event). The product's risk is therefore dependent in part upon the creditworthiness of the reference entity. This higher risk is rewarded with better terms, such as higher coupons and greater participation rates.
The credit quality may change during the lifetime of the product, and this influences the price of the product on the secondary market.
If a credit event occurs (i.e. the reference entity becomes insolvent during the lifetime of the product), the product becomes due prematurely. Investors are then credited with an amount per product, based on the market value of the reference bond at the time insolvency was declared. In practical terms, this means that investors may lose most or all of the money they have invested if such an event takes place.
Most reference entity certificates are collateral-secured instruments (COSI products) which eliminate the default risk of the individual product issuer almost entirely.