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What is a Credit Derivative? - De nition & Characteristics

Credit derivatives are a type of derivative that are used to transfer the risk of a loan or nancial transaction to a
third party. It is an instrument to hedge risk and will be discussed in this lesson.

Credit Derivative
What are derivatives for? More importantly, what is a credit derivative? How can we understand all
these nancial instruments?

Derivatives come in many di erent forms. These products are securities who prices depend on
the value of an underlying asset without owning the asset.

A credit derivative is a contract that allows parties to handle or transfer their exposure to risk. It is
a privately held negotiated bilateral agreement between two parties in a creditor/debtor
relationship. It allows the creditor to transfer the risk of a contract with a debtor to a third party.

For example, First Transfer Ltd. has just negotiated a loan with XYZ Corp. loaning them $500,000.
First Transfer does not want the risk that XYZ might not repay the loan so they negotiate a credit
derivative contract with First Loan Corp. For a fee paid by First Transfer to First Loan, First Loan will
assume the loss if XYZ defaults on the loan.

A credit derivative is a nancial contract whose value is determined by the default risk of the
underlying loan. It is basically an insurance policy against loss for the issuer of the credit derivative.
It is not associated with an underlying asset - security or commodity - like many of the other
derivative products.

Types of Credit Derivatives

There are some variations and types of credit derivatives which di er slightly from the basic
de nition of a credit derivative. Some of the types of credit derivatives include:

Credit default swaps (CDS)

Collateralized debt obligations (CDO)

Total return swaps

Credit default swap options

Credit spread forward

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11/7/2019 What is a Credit Derivative? - Definition & Characteristics | Study.com

In all cases, the price of these various credit derivatives are driven by the creditworthiness of the
parties involved. They each have a variation of how that default risk is priced or contracted for.

Contrast to Other Derivatives

Derivative products all stem from other nancial instruments or assets. Derivatives are securities
whose price depends on the value of an underlying asset like a stock's price or a bond's
coupon/interest. Many derivatives are used as hedges or insurance against a stock or security's
price moving in an adverse direction.

In essence, all derivative products are insurance products to protect against risk, especially credit
derivatives. However, derivatives are also used by investors to speculate and bet on the direction of
the movement of the underlying assets. They might think they have information about an
upcoming price movement and bet on that movement through buying options rather than buying
the asset itself.

The di erence of credit derivatives is that they are contracts and not a physical asset. There is no
stock, bond, or other nancial instrument underlying the credit derivatives. It is just a contract to
swap a default risk primarily on a loan made to a third party.

Example of a Credit Derivative

Credit derivatives are contracts usually involving three parties - the borrower, the lender, and the
party assuming the risk. Sometimes, all three parties are involved in the credit derivative
arrangement and other times it is only the lender and the party assuming the risk. Let's look at an
example where all three parties are involved.

ABC Inc. needs to borrow $200,000 from its bank, A liated Bank Ltd. ABC has had a history of bad
credit. A liated has reasons for making the loan but as part of the loan requirement, ABC is
required to purchase a credit derivative as a condition of the loan and pay the fees for the credit
derivative.

A liated Bank contacts First Union Bank and sells them ABC's credit derivative. First Union now
receives the annual fee that ABC is paying for the issuance of the credit derivative. First Union,
however, is now responsible for refunding any outstanding principal and interest to A liated if
ABC defaults on the repayment of the $200,000 loan.

A liated has kept a customer going by making the loan but has protected itself by transferring the
default risk to First Union Bank. The only way that Easy Touch can be harmed is if ABC defaults on
the loan at the same time that First Union goes into bankruptcy or defaults.

The value of the credit derivative is dependent on both the credit quality of the borrower and the
credit quality of the the third party, referred to as the counter party, assuming the risk. In this
example, the fee for the credit derivative would re ect the poor credit history of ABC Inc. If

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11/7/2019 What is a Credit Derivative? - Definition & Characteristics | Study.com

A liated Bank was concerned about the credit standing of First Union, it could increase the fee
paid by ABC and possibly retain some of the fees itself to protect itself against First Union
defaulting.

Bene ts and Risks

Credit derivatives are a widely used nancial instrument by nancial institutions. It has several
bene ts for nancial institutions making loans.

The credit derivative is insurance against the default of the borrow thus protecting the lender.

Having a credit derivative on the loan can improve the quality of the lender's loan portfolio.

By transferring the default risk to a third party, the lender can free up the ability to make additional loans.

However, there are inherent risks in using credit derivatives.

The lender still has the risk for the default of the loan if both the borrower and third party default on their
obligations.

Credit derivatives are an unregulated nancial instrument and traded over-the-counter so there is no
market for them.

Any defaults on credit derivatives or other derivatives could have a cascading e ect causing defaults in
other derivatives.

It is a useful tool for nancial institutions along as the credit derivative is done right and the risk is
transferred to another nancial institution that has a strong credit history.

Lesson Summary
Derivatives are nancial instruments that are issued or traded based on the value of an
underlying asset which the investor does not own. They come in many di erent forms but basically
the investor is speculating on the movement in value of the underlying asset.

Credit Derivatives are contracts between three parties to transfer the default risk of a loan. The
three parties are the lender, the borrower, and a third party nancial institution that assumes the
default risk. For a fee, the lender transfers the risk that the borrower will default on a loan to a
third party.

The use of credit derivatives by nancial institutions is a huge market, but since it is unregulated
there is no information about the size of the market or the number of transactions conducted each
year.

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