Posted in Finance, Accounting and Economics Terms, Total Reads: 578
Definition: Credit Derivative
Credit derivative is an instrument that lets a party pass on the credit risk of an underlying asset to another party, and reduce the credit exposure of self. The transfer of credit risk is done through instruments like forwards, options and swaps, which are priced based on the actual credit risk of the underlying.
The most common type of credit derivative is a Credit Default Swap (CDS).
A CDS contract involves a protection buyer and a protection seller. The protection buyer is the one who has lent to the borrower and wants to protect oneself from default risk of the borrower. A protection seller, on the other hand, is like an insurance company that insures the loaned amount in return for periodic payments from the protection buyer. The protection seller makes a payment to the protection buyer only in the case of a default (which could be bankruptcy, material default or debt restructuring).
Usually there is a set recovery rate up to which the protection buyer can recover from the protection seller. Generally, higher the recovery rate, more is the periodic payment. In case no default occurs on the underlying asset, the protection buyer gains nothing out of the transaction, but the protection seller gains from the periodic payments received.
Other types of credit derivative instruments are credit linked note and total return swap.