What is a Credit Derivative
A credit derivative consists of privately held negotiable bilateral contracts that allow users to handle their exposure to credit risk. Credit derivatives are financial assets such as forward contracts, swaps and options for which the price is driven by the credit risk of economic agents, such as private investors or governments.
BREAKING DOWN Credit Derivative
Credit derivatives transfer credit risk related to an underlying entity from one party to another without transfering the actual underlying entity. For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transfering the credit risk to another party while keeping the loan on its books.
There are many different types of financial instruments in the marketplace. Derivatives stem from other financial instruments, and as such the underlying value is directly connected to another asset, such as a stock. There are two main types of derivatives: puts and calls. A put is the right, but not the obligation, to sell a stock at a predetermined price referred to as the strike price. A call is the right, but not the obligation, to buy a stock at a predetermined strike price. Both puts and calls provide investors with insurance against a stock price going up or down. In essence, all derivative products are insurance products, especially credit derivatives.
Credit Derivative Example
There are many types of credit derivatives including credit default swaps (CDS), collateralized debt obligations (CDO), total return swaps, credit default swap options and credit spread forwards. In exchange for an upfront fee, referred to as a premium, banks and other lenders can remove the risk of default entirely from a loan portfolio. As an example, assume company A borrows $100,000 from a bank over a 10-year period. Company A has a history of bad credit and must purchase a credit derivative as a condition of the loan. The credit derivative gives the bank the right to "put" or transfer the risk of default to a third party. In other words, in exchange for an annual fee over the life of the loan, the third party pays the bank any remaining principal or interest on the loan in case of default. If company A does not default, the third party gets to keep the fee. Meanwhile, company A receives the loan, the bank is covered in case of default on company A, and the third party earns the annual fee.
Everyone is happy.
The value of the credit derivative is dependent on both the credit quality of the borrower and the credit quality of the third party, referred to as the counterparty. However, the credit quality of the counterparty is more important than the borrower. In the event the counterparty goes into default or cannot honor the derivatives contract, the lender does not receive a payment and the premium payments end.