Definition
The term credit derivative refers to an agreement that moves credit risk from one party to the other. Credit derivatives were originally used by participants in the banking industry to diversify the credit risk of customers in their lending portfolio.
Explanation
The term derivative refers to any type of financial contract derived from another financial contract. Credit derivatives are financial agreements initially entered into by banks to move the risk associated with the financial agreements they established as lenders. Specifically, they would find a counterparty willing to assume the risk of non-payment on money they've lent customers.
Today, most credit derivatives take the form of credit default swaps or CDS. The seller of the CDS will compensate the buyer if one of the debtors goes into default on the loan. In this manner, the seller of the CDS insures repayment. In turn, the buyer of the CDS will make a series of payments to the seller. In this example, the seller of the CDS acts like an insurance company, and collects a fee for standing ready to pay the buyer of the CDS in the event the original issuer of the debt defaults on their loan. In exchange for the premium paid to the seller, the buyer of the CDS is protected from default on the debt instrument they hold.
CDS are especially important to investors looking to hold onto a bond until it matures. When first issued, a bond may carry with it repayment terms of ten years or more. While the company issuing the bond may be in sound financial condition at the time of purchase, that may not be the case in the future. It is this risk that is mitigated by this type of credit derivative.
Related Terms
The term differential refers to the allowed flexibility to change the quality of the underlying asset in a futures contract. Differential allows the seller in a futures contract to deliver the underlying asset which adheres to a predetermined range of quality specifications.
Moneyzine EditorNovember 6th, 2024
The term devaluation refers to the reduction in the value of a currency relative to the currency of another country. Devaluation typically occurs through an official announcement and the process is a tool governments can use to control monetary policy.Moneyzine EditorNovember 6th, 2024
The term deliverable grade refers to the minimum quality of a commodity delivered under a futures contract. The specifications for deliverable grades are critical to the pricing of a contract.Moneyzine EditorNovember 6th, 2024
The term default refers to the failure to meet an obligation on a loan or futures contract. Default occurs when a debtor fails to repay the interest and / or principal owed a lender.Moneyzine EditorNovember 6th, 2024
The term daily trading limit refers to the maximum range a derivative contract is permitted to trade in any one daily session. Daily trading limits are established by the exchange to protect against market manipulation.Moneyzine EditorNovember 6th, 2024
The term currency risk refers to the relative change in the valuation of two currencies and the impact it has on return on investment. Both investors as well as businesses that own assets in countries with different currencies are exposed to currency risk.Moneyzine EditorNovember 6th, 2024
The term closing range refers to the high and low price at which trades occurred at the close of the exchange. The closing range would include both bid and offer prices.Moneyzine EditorNovember 6th, 2024
