Credit Derivative

"Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity."

A derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.

The parties will select which credit events apply to a transaction and these usually consist of one or more of the following:

a.) Bankruptcy (the risk that the reference entity will become bankrupt)
b.) Failure to pay (the risk that the reference entity will default on one of its obligations such as a bond or loan)
c.) Obligation default (the risk that the reference entity will default on any of its obligations)
d.) Obligation acceleration (the risk that an obligation of the reference entity will be accelerated e.g. a bond will be declared immediately due and payable following a default)
e.) Repudiation/moratorium (the risk that the reference entity or a government will declare a moratorium over the reference entity's obligations)
f.) Restructuring (the risk that obligations of the reference entity will be restructured).

Where credit protection is bought and sold between bilateral counterparties, this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.

This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic CDOs; credit linked notes; single tranche CDOs, to name a few. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite.