DEFINITION of 'Credit Default Contract'

A credit default contract is a general term for securities with a risk level and pricing based on the risk of credit default by one or more underlying security issuers. Credit default contracts include credit default swaps (CDS), credit default index contracts, credit default options and credit default basket options. Credit default contracts are also used as part of the mechanism behind many collateralized debt obligations (CDOs); in these cases, the contracts may have unique covenants that exclude company events such as a debt restructuring as a credit event.

BREAKING DOWN 'Credit Default Contract'

 

Credit default contracts establish a price for a given default risk, where it can then be traded to another party who wishes to accept it. For financial institutions, credit default contracts are a way to diversify credit risks by sharing them with the market. For companies and investors, a credit default contract can remove some of the risk of an asset without requiring the sale of that asset. For the speculators trading in credit default contracts without a stake in the underlying, these contracts offer a way to bet on credit ratings and profit from pricing mistakes in the market.

The Market Boom for Credit Default Contracts

Growth of credit default contracts exploded from the late 1990s to the early 2000s. The liquidity of these products and the ability to track reference entities and events improves as institutional investors piled in. They are a versatile tool for transferring risk away from a lender's balance sheet (such as in CDS) or for pure speculation by hedge funds and other investment vehicles. In fact, the situation reached a point where the outstanding credit default contracts on an underlying security were worth many times more than the value of the underlying.

Credit Default Contract Issues After the Financial Crisis

In addition to the breakneck growth in the size of the market, credit default contracts started to be gathered up into synthetic CDOs, allowing more unrecognized liability to build up in the system. The credit default contract market was shaken several times leading up to the financial crisis, but it finally blew up along with everything else after the Lehman Brothers collapse. The credit default contract market lost its unregulated status following the financial crisis and shrank to a tenth of the size in the following years.

Some structural issues still haunt the market for credit default contracts. Although these products are billed as insurance, they are in fact tradable instruments and are not as highly regulated as the insurance industry. A credit default contract seller could, for example, intervene on behalf of the reference entity or company to provide the financing necessary to avoid a credit event and there would be nothing overtly illegal about that. That said, the market is still useful for financial institutions and investors. It may not reach the heights it once enjoyed, but the credit default contract market will continue to operate.

RELATED TERMS
  1. Default

    Default is the failure to promptly pay interest or principal ...
  2. Temporary Default

    A bond rating that suggests the issuer might not make all of ...
  3. Credit Default Swap - CDS

    A particular type of swap designed to transfer the credit exposure ...
  4. Credit Exposure

    Credit exposure is the total amount of credit extended to a borrower ...
  5. Default Risk

    Default risk is the event in which companies or individuals will ...
  6. Reference Entity

    A reference entity is the issuer of the debt that underlies a ...
Related Articles
  1. Insights

    Why and When Do Countries Default?

    Countries can default on their debt. This happens when the government is either unable or unwilling to make good on its fiscal promises.
  2. Investing

    How Credit Rating Risk Affects Corporate Bonds

    Credit migration risk is a vital part of the credit risk assessment, specifically with regard to corporate bonds which underlie numerous rating changes.
  3. Investing

    7 Things You Didn’t Know About Sovereign Debt Defaults

    Sovereign debt defaults are scary, but should they be? They are actually more common than you think.
  4. Investing

    Energy Sector in Hot Water, Defaults Keep Rising

    Fitch expects U.S. oil company default rates to pick up in 2017 despite stable oil prices.
  5. Financial Advisor

    Emerging Market Defaults: Beware of Second Wave

    Emerging market corporate defaults have the potential to be the biggest risk to global markets.
  6. Personal Finance

    Credit Risk Analyst: Job Description and Average Salary

    Learn what credit risk analysts do every day and how much money they make on average, and identify the skills and education needed for this career.
  7. Investing

    Market Tremors in Credit Default Swaps

    The market for credit default swaps has taken a hit lately.
  8. Investing

    High-Yield Bond ETFs: 3 Reasons to Avoid Them

    Examine high-yield bond performance in 2016. Why do rising default rates, falling recovery rates and Fed rate hikes make these securities worth avoiding?
  9. Personal Finance

    6 Ways To Build Credit Without A Credit Card

    It's definitely possible – if a bit more complicated – to build a credit history without traditional credit cards. Just follow these steps.
  10. Personal Finance

    Is Your Credit Score at 850? It Can Be!

    Use these tips to increase your credit score and your ability to get low interest rates on loans.
RELATED FAQS
  1. What factors are taken into account to quantify credit risk?

    Learn how probability of default, or PD; loss given default, or LGD; and exposure at default, or EAD, are used to help quantify ... Read Answer >>
  2. Why do high profiting sales mitigate credit risk?

    Learn more about credit risk in loaning to individuals and businesses. Understand how credit risk is determined and the impact ... Read Answer >>
  3. What are some examples of risks associated with financial markets?

    Find out about the different types of risks for different classes of assets including volatility, counterparty risk and default ... Read Answer >>
  4. Forward Contracts vs. Futures Contracts

    While both forward and futures contracts allow people to buy or sell a specific asset at a specific time at a given price, ... Read Answer >>
Hot Definitions
  1. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  2. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  3. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  4. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  5. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  6. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
Trading Center