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Credit Derivatives

By: EconomyWatch Content Date: 16 March 2010

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Credit derivatives are those products that have credit as their underlying asset. The aim of credit derivatives is to transfer the risk to a third party, other than the counterparties involved in the transaction. The third party in such transactions is called the reference entity and could be a corporate or any form of legal entity that has incurred debt. Credit derivatives, in a nutshell, are bilateral contracts, under which seller sells protection against the risk of the reference entity.

Different Terms of Credit Derivatives

There are different terms and condition for every credit derivative product. If these events occur during the contract, the reference party has to cover the risk. Listed below are some situations that are considered by the parties:

Bankruptcy
Failure to pay
Obligation default
Obligation acceleration
Repudiation/moratorium
Restructuring

When credit protection is sold between bilateral counterparties, it is known as an unfunded credit derivative. However, if a financial institution or a special purpose vehicle (SPV) uses securitization techniques and the debt obligation is issued by them, such credit derivatives are called funded credit derivatives. A highlight of funded credit derivatives is the credit rating that they accompany.

The Booming Market of Credit Derivatives

Of late, the growth in the US and European markets has been phenomenal. This growth has been spurred by the bridging act that credit derivatives deliver for commercial banks and other financial institutions, such as mutual funds or insurance companies.

Traditionally, the loan market, which offers one of the highest returns in the money market, is not easily accessible to other financial institutions. With credit derivatives, banks get a chance to reduce the credit risk that most had to suffer due to the economical turmoil. Banks get a chance to trade default risk as a separate exposure and other financial institutions, most willingly, buy them.

Credit derivatives also open a parallel market of tradable securities. Banks get an opportunity to protect themselves against ‘bad assets’ and also make credit risks amenable to trading, which otherwise is not possible.

Credit derivatives can also be thought of insurance against default risk associated with credit. Banks have to also make initial payments (to seek protection) to the institution that offers protection.