A credit derivative is a type of derivative agreement that allows parties to buy and sell protection on credit products. Under a credit derivatives contract, one party typically sells all or part of the credit risks associated with a credit product or a bundle of credit products to another party. The entity selling the risk generally retains ownership of the credit product, even after the credit risk has been transferred to the entity assuming the risk. Credit derivatives can provide entities with ways to create or to reduce credit exposure associated with loan default, foreclosure, bankruptcy or interest rate and exchange rate movements.
For example, Bank A may believe that it has entered into several high-risk installment loans with various customers. To help reduce the credit exposure associated with the loans, Bank A may enter into a credit derivatives agreement with Bank B. Pursuant to that agreement, all or part of the credit risk associated with this bundle of loans may be transferred to Bank B. Although the loans will remain on Bank A’s balance sheet, the credit exposure will belong to Bank B. Bank B will agree to bear the risk in exchange for a fee paid by Bank A.
In the credit derivatives market, a number of credit products can be transferred between buyers and sellers. Credit risks associated with credit assets, such as loans or mortgages, are commonly traded credit products. Parties may also enter into credit risk derivatives contracts that cover generic credit exposure. For example, an entity may wish to transfer some or all of the credit risks associated with its own bankruptcy.
Entities wishing to buy or sell credit risk may participate in the credit derivatives trading market. Banks, hedge funds or insurance companies are parties who frequently agree to assume risk associated with credit products. Traded credit derivative products can include credit default products, credit default swaps, and collateralized debt obligations.
While a variety of credit derivatives agreements exist, some of the most common types include swaps, options and futures. Credit derivative swaps are agreements to exchange one stream of cash flow against another stream on or before a set date in the future based on a set calculation. Under an options derivative contract, a party secures the right, but the not obligation, to buy or sell an asset at a future date and at a price set at the time the contract is entered into. A futures derivative agreement is a contract to transfer an asset on or before a set date in the future, based a price set at the time the contract is entered into.