What Is a Credit Derivative?

A credit derivative is a financial asset that allows parties to handle their exposure to risk. Credit derivative consisting of a privately held, negotiable bilateral contract between two parties in a creditor/debtor relationship. It allows the creditor to transfer the risk of the debtor's default to a third party.

Various types of credit derivatives exist, including

In all cases, their price is driven by the creditworthiness of the parties involved, such as private investors or governments.

The Basics of a Credit Derivative

As their name implies, derivatives stem from other financial instruments. These products are securities whose price depends on the value of an underlying asset, like a stock's share price or a bond's coupon. In the case of a credit derivative, the price derives from the credit risk of one or more of the underlying assets.

There are two main types of derivatives puts and calls. A put is a right—not obligation—to sell the asset at a decided price, known as the strike price. A call is a right without obligation, to buy the underlying at the predetermined strike price. Investors use both puts and calls to hedge or give insurance against a stock price moving in an adverse direction.

In essence, all derivative products are insurance products, especially credit derivatives. Derivatives are also used by speculators to bet on the direction of movement of the underlying assets.

The credit derivative, while being a security, is not a physical asset. Instead, it is a contract. The contract allows for the transfer of the credit risk related to an underlying entity from one party to another without transferring 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 transferring the credit risk to another party while keeping the loan on its books.

Key Takeaways

  • A credit derivative is a financial asset in the form of a privately held bilateral contract between parties in a creditor/debtor relationship.
  • A credit derivative allows the creditor to transfer the risk of the debtor's default to a third party, paying it a fee to do so.
  • Types of credit derivatives exist, including credit default swaps (CDSs), collateralized debt obligations (CDOs), total return swaps, credit default swap options, and credit spread forward.

How a Credit Derivative Works

Banks and other lenders can use credit derivatives to remove the risk of default entirely from a loan portfolio—in exchange for paying an upfront fee, referred to as a premium.

As an example, assume company A borrows $100,000 from a bank over a 10-years. 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 by company A, and the third party earns the annual fee. Everyone is happy.

Valuing a Credit Derivative

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.

The credit quality of the counterparty is more important to the valuing of the credit derivative than that of the borrower. In the event the counterparty goes into default or in some other way cannot honor the derivatives contract—to pay off the underlying loan—the lender is at a loss. They do not receive the loaned principal returned, but no longer have to pay the third party their premium. On the other hand, if the counterparty has a better credit rating than the borrower, it increases the quality of the debt overall.

Credit derivatives are traded over-the-counter (OTC). This method of trading means they are non-standardized—not subject to exchange the Securities and Exchange Commission (SEC) regulations. This lack of regulation translates to much speculative trading in the product.

Further, the chain of ownership of an instrument can become very convoluted, and the details of its terms murky. Misuse of credit derivatives played a key role in the global financial crisis of 2007-09.

Pros

  • Offer insurance against default

  • Can improve quality of debt

  • Free up capital

Cons

  • Traded over-the-counter (non-standardized/non-regulated)

  • Difficult to track

  • Lack transparency

Real World Example of Credit Derivatives

The U.S. Comptroller of the Currency (OCC) issues a quarterly report on credit derivatives. For the fourth quarter of 2018, in a report issued in March 2019, it placed the size of the entire credit derivatives market at $4.3 trillion.

Credit default swaps, the most common form of credit derivative, accounted for $3.7 trillion, or nearly 87% of the market.