What Is a Credit Derivative?

A credit derivative is a financial contract that allows parties to minimize their exposure to credit risk. Credit derivatives consist of a privately held, negotiable 澳洲幸运5开奖号码历史查询:bilateral contract traded over-the-counter (OTC) between two parties in a creditor/debtor relationship. These allow the creditor to effectively transfer some or all of the risk of a debtor defaulting to a third party. This third party accepts the risk in return for payment, known as the🦂 premium.

Several types๊ of credit derivatives exist, including:

• 澳洲幸运5开奖号码历史查询:Credit default swaps (CDS)
• 澳洲幸运5开奖号码历史查询:Collateralized debt obligations (CDO)
• 澳洲幸运5开奖号码历史查询:Total return swaps
• 澳洲幸运5开奖号码历史查询:Credit spread options/forwards

In all cases, the price of a credit derivative is driven by the perceived 澳洲幸运5开奖号码历史查询:creditworthiness of the party or parties involved. A credit derivative contract will be triggered by a qualifying 澳洲幸运5开奖号码历史查询:credit event, such as a default, missed interest payment, credit downgrade, or bankruptcy. However, a change in the market price of the derivatiꦑve could be triggered by the mere anticipation of a credit event.

Understanding a Credit Derivative

As their name implies, 澳洲幸运5开奖号码历史查询:derivatives stem from other financial instruments. These products are securities whose price depends on the value of an 澳洲幸运5开奖号码历史查询:underlying asset, such as a stock's share price or a bond's coupon. In the case of a credit derivative, the price derives from the credit risk of one or more of the underlying asse🍌ts.

A long put is a right (though not an obligation) to sell an asset at a set price, known as the strike price, while a long call is a right (though not an obligation) to buy the underlying asset at a set price. Investors use long puts and calls to hedge or provide insurance against an asset moving in an adverse price direction. The flip side of these types of trades is short puts and calls, whereby the person entering into a short position has the obligation to purchase the a🌠sset, in the case of the put, or sell the asset, in the case of a call.

In essence, all derivative products are insurance products, especially credit derivatives. Derivatives are also used by 澳洲幸运5开奖号码历史查询:speculators to bet on the directio꧂n of the underಌlying assets.

The credit derivative, while being a security, is not a physical asset. Instead, it is a contract. The contract allows for the transfer of credit risk related to an underlying entity from one party to another without transferring the actual underlying entity. For example, a bank concerned a borrower may not be able to repay a loan can protღect itself by transferring the credit risk to anotꦗher party while keeping the loan on its books.

Example of a Credit Derivative

Banks and other lenders use credit derivatives to remove the risk of default from a loan portfolio—in exchange for paying a fee, referred to as a🧸 premium.

Assume Company ABC borrows $10 million from a bank. Company ABC has a bad 澳洲幸运5开奖号码历史查询:credit history and must buy a credit derivative as a condition of the loan. The credit derivative gives the bank the right to "put" the risk of default onto a third party, thereby trans﷽ferring the risk to this third party.

In other words, the third party promises to pay back the loan and any interest should Company ABC default, in exchange for receiving an annual fee over the life of the loan. If Company AB🔴C does not default, the third party profits in the form of the annual fee. Meanwhile, Company ABC receives the loan, and the bank is ꦛcovered in case of default. Everyone is happy.

Valuing Credit Derivatives

The value of a credit derivative is dependent on the credit quality of the borrower, the credit quality of the third party (referred to as the 澳洲幸运5开奖号码历史查询:counterparty), and market participants' perception o♍f both these values.

In placing a value on the credit derivative, the credit quality of the counterparty is more important than that of the borrower. In the event the counterparty goes into default or in some way cannot honor the derivatives contract—pay off the underlying loan—the lender is at a loss. They would not receive the return of their 澳洲幸运5开奖号码历史查询:principal and they are ouꦜt the feꦆes paid to the third party.

On the other hand, if the counterparty has a better 澳洲幸运5开奖号码历史查询:credit rating than the ❀borrower, it increases the quality of the debt over🥂all.

Credit derivatives are traded 澳洲幸运5开奖号码历史查询:over-the-counter (OTC). In 2010, the Dodd-Frank Wal🎃l Street Reform and Consumer🦋 Protection Act split regulation of the OTC swaps market between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).

Prior to this, a lack of regulation and oversight led to much speculative trading in the product. Furthermore, the chain of ownership of an instrument was very convoluted, and the details of the terms were murky. Misuse of credit derivatives played a key role in the 澳洲幸运5开奖号码历史查询:2007-08 financial crisis.

Credit Derivative Benchmark Indices

While credit derivatives usually trade OTC, there are now various credit derivative indexes that traders can use as a benchmark to value the performance of their holdings. Most of these indexes track and measure total returns for the various segments of the bond issuer market focusing on CDS.

For instance, The 澳洲幸运5开奖号码历史查询:credit default swap index (CDX), formerly the Dow Jones CDX, is a benchmark financial instrument made up of CDS that have been issued by North American or emerging market companies. The CDX was the first CDS index, which was created in the early 2000s and was based on a basket of single issuer CDSs.

The CDX is itself a tradable security: a 澳洲幸运5开奖号码历史查询:credit market derivative. But the CDX index also functions as a shell, or container, as it is made up of a collection of other credit derivatives: credit default swaps (CDS).