A credit derivative is a financial contract in which the underlying is a credit asset (debt or fixed-income instrument). The purpose of a credit derivative is to transfer credit risk (and all or part of the income stream in relation to the borrower) without transferring the asset itself. A credit derivative serves as a sort of insurance policy allowing an originator or buyer to transfer the risk on a credit asset (of which he may or may not be the owner) to the seller(s) of the protection or counterparties.

2. • A credit derivative consists of privately held
negotiable bilateral contracts that allow users
to handle their exposure to credit risk. Credit
derivatives are financial assets such as
forward contracts, swaps and options for
which the price is driven by the credit risk of
economic agents, such as private investors or
governments.

3. UNDERSTANDING CREDIT DERIVATIVES
• Credit derivatives transfer 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.

4. UNDERSTANDING CREDIT DERIVATIVES
• There are many different types of financial instruments in the
marketplace. Derivatives stem from other financial instruments,
and as such the underlying value is directly connected to another
asset, such as a stock. There are two main types of derivatives:
puts and calls. A put is the right, but not the obligation, to sell a
stock at a predetermined price referred to as the strike price. A
call is the right, but not the obligation, to buy a stock at a
predetermined strike price. Both puts and calls provide investors
with insurance against a stock price going up or down. In
essence, all derivative products are insurance products,
especially credit derivatives.

5. EXAMPLE FOR CREDIT DERIVATIVE
• There are many types of credit derivatives including credit default
swaps (CDS), collateralized debt obligations (CDO), total return
swaps, credit default swap options and credit spread forwards. In
exchange for an upfront fee, referred to as a premium, banks and
other lenders can remove the risk of default entirely from a loan
portfolio. As an example, assume company A borrows $100,000
from a bank over a 10-year period. 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.

6. EXAMPLE FOR CREDIT DERIVATIVE
• 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 on company A, and the third party earns the
annual fee. Everyone is happy.
• 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. However, the credit quality of the
counterparty is more important than the borrower. In the event the
counterparty goes into default or cannot honor the derivatives
contract, the lender does not receive a payment and the premium
payments end.

7. TYPES OF CREDIT DERIVATIVES
• A credit derivative is a financial instrument that transfers
credit risk related to an underlying entity or a portfolio of
underlying entities from one party to another without
transferring the underlying(s). The underlyings may or
may not be owned by either party in the transaction. The
common types of credit derivatives are Credit Default
Swaps, Credit Default Index Swaps (CDS index),
Collateralized Debt Obligations, Total Return Swaps,
Credit Linked Notes, Asset Swaps, Credit Default Swap
Options, Credit Default Index Swaps Options and Credit
Spread Forwards/Options.

8. TYPES OF CREDIT DERIVATIVES

9. CREDIT DEFAULT SWAPS
A credit default swap is a financial swap agreement that the
seller of the CDS will compensate the buyer in the event of a
debt default or other credit event. That is, the seller of the
CDS insures the buyer against some reference asset
defaulting.

10. CREDIT-LINKED NOTES
A credit linked note is a form of funded credit derivative. It is
structured as a security with an embedded credit default swap
allowing the issuer to transfer a specific credit risk to credit
investors. The issuer is not obligated to repay the debt if a
specified event occurs.

11. CREDIT OPTIONS
• A credit spread option is a
financial derivative
contract that transfers
credit risk from one party
to another. An initial
premium is paid by the
buyer in exchange for
potential cash flows if a
given credit spread
changes from its current
level.

12. CREDIT INTERMEDIATION SWAPS
• A credit default swap with
the notional linked to the
mark-to-market of a
reference swap or portfolio
of swaps.It is also called a
credit intermediation swap.

13. CDS INDEXES
• A credit default swap index is
a credit derivative used to
hedge credit risk or to take a
position on a basket of credit
entities.This means that it can
be cheaper to hedge a
portfolio of credit default
swaps or bonds with a CDS
index than it would be to buy
many single name CDS to
achieve a similar effect.

14. TOTAL RATE OF RETURN SWAPS
• A total return swap is a swap
agreement in which one party
makes payments based on a
set rate, either fixed or
variable, while the other party
makes payments based on the
return of an underlying asset,
which includes both the
income it generates and any
capital gains.

15. SYNTHETIC CDOs
• A synthetic CDO is a collateralized debt obligation (CDO) that invests
in credit default swaps (CDSs) or other noncash assets to obtain
exposure to a portfolio of fixed income assets. Synthetic CDOs are
typically divided into credit tranches based on the level of credit risk
assumed.

16. BASKET CREDIT DEFAULT SWAP
• A basket default swap is
similar to a single entity
default swap except that the
underlying is a basket of
entities rather than one single
entity. ... Similarly, an all-to-
default swap protects against
losses resulting from credit
events of any of the entities in
the basket.

17. CONCLUSION
• In 1998, the most crucial challenge faced by the credit derivatives
market at the time: the creation of liquidity. How much ground has
been covered over the past seven years!
• Several factors have contributed to the increase in liquidity on the
CDS market, and they have ensured that CDSs have become
mainstream capital market instruments. These factors include:
• Standardization of legal contracts.
• Clarification of the regulations (for banks).
• Advances in information technology, risk management processes
and trading infrastructures.
• Emergence of market standards for structuring, modeling and
pricing.

18. CONCLUSION
• The unprecedented default wave of 2001–2002 also challenged
the resilience of the credit derivatives market and proved its
solidity. This ‘baptism of fire’ gave credit derivatives a central role
in the capital markets, which will no doubt grow in the years to
come. Their strong growth has in turn broadened the range of
applications and number of users, and further fuelled product
innovation.
• It is very likely that the credit derivatives market will grow in an
already-established pattern, like that followed by interest rate,
currency and equity derivatives: pioneered by banks, often for
their own needs, these other forms of derivatives were then
offered to a sophisticated customer base of institutional investors,
before being extended to the ‘mass market segments’ of
corporates, retail and private banking investors. ...