Credit Derivative: Definition, Types, and Potential Misuse

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 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 types of credit derivatives exist, including:

• Credit default swaps (CDS)
• Collateralized debt obligations (CDO)
• Total return swaps
• Credit spread options/forwards

In all cases, the price of a credit derivative is driven by the creditworthiness of the party or parties involved. Often a credit derivative will be triggered by a qualifying credit event, such as a default, missed interest payment, credit downgrade, or bankruptcy.

Understanding a Credit Derivative

As their name implies, derivatives stem from other financial instruments. These products are securities whose price depends on the value of an 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 assets.

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 asset, 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 speculators to bet on the direction of the underlying 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 protect itself by transferring the credit risk to another 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 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 transferring 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 ABC does not default, the third party profits in the form of the annual fee. Meanwhile, Company ABC receives the loan, and the bank is covered in case of default. Everyone is happy.

Valuing Credit Derivatives

The value of a 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.

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 principal and they are out the fees paid to the third party.

On the other hand, if the counterparty has a better credit rating than the borrower, it increases the quality of the debt overall.

Credit derivatives are traded over-the-counter (OTC). In 2010, the Dodd-Frank Wall 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 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 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 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).