Funded and Unfunded Credit Derivatives
Credit derivatives can be classified as funded and unfunded.
Credit default swaps (CDS) are an example of unfunded credit derivatives. In such a swap, the credit protection seller does not make any upfront payment to the protection buyer. The seller will make a payment to the buyer to cover the losses only when a credit event occurs. Another example of unfunded credit derivatives is total return swaps.
However, in a funded credit derivative, the credit protection seller makes an upfront payment to the credit protection buyer. Such transactions generally involve a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques. A debt obligation is issued by the financial institution or SPV to support these obligations. Examples are credit-linked notes, and collateralized debt obligations. For example, in a credit-linked note, the credit protection buyer is the seller of the note. The credit protection seller (the investor) makes an upfront payment and buys the note. If no credit event occurs, the investor receives the redemption value of the note on its maturity. If a credit event does occur, the investor is paid the redemption value less the nominal value of the reference asset. The exact calculation of the actual payment will differ based on whether it is cash settlement, or physical settlement, and other factors.