A Credit Derivative is a contract to transfer the risk of the total return
on a credit asset falling below an agreed level, without transfer of the
underlying asset. This is usually achieved by transferring risk on a credit
reference asset. Early forms of credit derivative were financial guarantees.
Some common forms of credit derivatives are
* Total return swap
* Credit default swap
* Credit linked note.
Key concepts of the credit derivatives market
The idea of credit derivatives is to avoid direct ownership of the
securities referenced in the transaction. This is achieved, as elsewhere in
financial markets, by the use of a reference rate and other reference
concepts such as
* Reference entity (aka reference credit) A specified legal entity, which
may be a sovereign, financial institution, corporation, or one of a
number of specified entities.
* Reference Asset - a generic term for any holding, obligation, debt or
other form of credit instrument that is "referenced" in the transaction
* Reference Security. Usually, a public security issued by the reference
entity, but also a reference asset or reference obligation such as a
loan or other financial asset.
* Credit Event. An event defined within the credit derivatives contract,
that happens in respect of the reference entity. It is usually defined
in the Master Agreement of a credit derivatives contract. For example,
the six credit events under ISDA (1999) definitions are Bankruptcy,
Obligation Acceleration, Obligation Default, Failure to Pay,
Note that, as a result of a recent confusion about what constitutes certain
credit events, the ISDA agreement has recently changed.
Total return swap
A total return swap (a.k.a. Total Rate of Return Swap) is a type of credit
derivative that swaps the "total return" of a credit asset against a
contractually determined return. Typically, one party receives the total
return (interest payments plus any capital gains or losses) from a specified
reference asset, while the other receives a specified fixed or floating cash
flow that is not related to the creditworthiness of the reference asset.
Credit default swap
The Credit default swap or CDS is now the main engine for the credit
derivatives market, offering liquid price discovery and trading on which the
rest of the market is based. It is an agreement between a protection buyer
and a protection seller whereby the buyer pays a periodic fee in return for
a contingent payment by the seller upon a credit event happening in the
reference entity. The contingent payment is usually represents the loss
incurred by creditors of the reference entity in the event of its default.
It covers only the credit risk embedded in the asset, risks arising from
other factors such as interest rate movements remaining with the buyer.