Credit Derivatives: Actual Default Vs. Technical Default

In a credit derivative contract, the protection seller will make the payment on the occurrence of a credit event. There are a number of events that can be defined as credit events.

One such event is default, which could be a technical or an actual default.

A default happens when a counterparty defaults on its payment. It will be referred to as a technical default it if is just a delay in payment and the obligor still intends to pay in a time frame of another one to three months. Since the obligor intends to pay it cannot be considered as actual default. A default will be classified as actual default only when it is actually in defaults and declares that it is in default. In such a case, the rating agencies will also downgrade the obligor and change its rating to “D”.

The credit event needs to clearly state whether the event is based on actual or technical default or both. These details will be clearly specified in the credit derivative contract.