What Is a Credit Derivative?
A credit derivative is a financial contract that allows parties to minimize their exposure to credit risk. Credit derivatives consist of a privately held, negotiable bilateral contract between two parties in a creditor/debtor relationship. It allows the creditor to transfer to a third party the potential risk of a debtor defaulting.
Various types of credit derivatives include:
- Credit default swaps
- Collateralized debt obligations
- Total return swaps
- Credit default swap options
- Credit spread forwards
In all cases, the price of a credit derivative 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 in which their price depends on the value of an underlying asset, such as 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 (though not an obligation) to sell an asset at a set price, known as the strike price. A call is a right (though not an obligation) to buy the underlying at a set price. Investors use puts and calls to hedge or provide insurance against an asset moving in an adverse price direction.
In essence, all derivative products are insurance products, especially credit derivatives. Derivatives are also used by speculators to bet on the direction 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 credit risk related to an underlying entity from one party to another without transferring the actual underlying entity. For example, a bank concerned a borrower may not be able to repay a loan can protect itself by transferring the credit risk to another party while keeping the loan on its books.
- A credit derivative is a privately held bilateral contract between parties in a creditor/debtor relationship.
- A credit derivative allows the creditor to transfer to a third party the potential risk of the debtor defaulting, paying a fee to do so.
- Credit derivatives include credit default swaps, collateralized debt obligations, total return swaps, credit default swap options, and credit spread forwards.
How a Credit Derivative Works
Banks and other lenders use credit derivatives to remove the risk of default from a loan portfolio—in exchange for paying a fee, referred to as a premium.
Assume Company ABC borrows $10 million from a bank. Company ABC has a bad credit history and must buy a credit derivative as a condition of the loan. The credit derivative gives the bank the right to "put" the risk of default onto a third party, thereby transferring the risk to this third party.
In other words, the third party promises to pay back the loan and any interest should Company ABC default, in exchange for receiving an annual fee over the life of the loan. If Company ABC does not default, the third party profits in the form of the annual fee. Meanwhile, Company ABC receives the loan, the bank is covered in case of default, and the third party earns the annual fee. Everyone is happy.
Valuing a Credit Derivative
The value of a 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.
In placing a value on the credit derivative, the credit quality of the counterparty is more important than that of the borrower. In the event the counterparty goes into default or in some way cannot honor the derivatives contract—i.e. pay off the underlying loan—the lender is at a loss. They would not receive the return of their principal and they are out the fees paid to the third party. 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). In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act split regulation of the OTC swaps market between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
Prior to this, a lack of regulation and oversight led to much speculative trading in the product. Furthermore, the chain of ownership of an instrument was very convoluted, and the details of terms were murky. Misuse of credit derivatives played a key role in the 2007-08 Financial Crisis.
Real-World Example of Credit Derivatives
The Office of the Comptroller of the Currency (OCC) issues a quarterly report on credit derivatives. For the first quarter of 2020, the credit derivatives market was estimated at $4 trillion. Credit default swaps accounted for $3.5 trillion, or about 87.5% of the market.