What is a Credit Derivative? - Definition & Characteristics

Instructor: LEROY (Bill) RANDS

Bill has taught college undergraduate and MBA classes in finance, economics & management, 40 years of finance experience and has a MBA degree.

Credit derivatives are a type of derivative that are used to transfer the risk of a loan or financial 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 financial instruments?

Derivatives come in many different 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 financial 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 differ slightly from the basic definition 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

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 financial 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 difference of credit derivatives is that they are contracts and not a physical asset. There is no stock, bond, or other financial 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, Affiliated Bank Ltd. ABC has had a history of bad credit. Affiliated 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.

Affiliated 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 Affiliated if ABC defaults on the repayment of the $200,000 loan.

Affiliated 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.

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