What are Credit Derivatives?

As we know, derivatives are bilateral financial instruments that are used to shift the risk from one party to another. The value of a derivative instrument is derived from the underlying, such as the interest rate, index, or the financial asset.

The credit derivatives are specifically used to shift the credit risk from one party to the other and it's value is derived from the credit performance of the underling credit exposure. The underlying credit exposure belongs to an entity other than the counterparties to the credit derivative and is is known as the reference entity. The reference entity could be corporates, sovereigns, or any other legal entities.

The most common type of credit derivatives are credit default swaps (CDS). A is a contractual agreement which shifts the credit risk of one or more reference entities from one one party to the other. Assume that Bank A has extended a loan to Corporate C and wants to protect itself against Corporate A defaulting. In this case Corporate C, is the reference entity. Bank A wants to buy credit protection. Bank B agrees to sell credit protection to Bank A in return for a fees per annum for the life of the agreement. So, Bank A will pay the fees to bank B. In case the reference entity defaults on its payment, or in case of any other credit event, Bank B will be required to may the payment to Bank A to cover the losses.

There are many other popular credit derivative products such as Total Return Swaps, Credit Spread Options, and Asset Swaps. We will look at these products in the other posts.