Definition§
Credit Derivative refers to a financial instrument whose value is derived from the credit risk associated with the underlying entity, typically in the form of debt obligations. The primary purpose is to transfer credit risk from one party to another without transferring the underlying asset.
There are two main types of credit derivatives:
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Unfunded Credit Derivative: A contract between two parties where the protection seller assumes the credit risk from the protection buyer in exchange for periodic payments. A common example is a Credit Default Swap (CDS).
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Funded Credit Derivative: A structured finance product where credit risk is packaged into tradable instruments, such as securities. One prominent example is a Collateralized Debt Obligation (CDO).
Examples§
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Credit Default Swap (CDS): An unfunded arrangement where the protection seller compensates the buyer if the underlying entity defaults.
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Collateralized Debt Obligation (CDO): A funded instrument that pools various debt securities and then issues new tranches of securities with varying risks and returns.
Frequently Asked Questions (FAQs)§
What is the primary difference between a funded and unfunded credit derivative?§
Funded credit derivatives involve the creation of a financial instrument that is traded in the market, which pools and repackages credit risk (e.g., CDO). Unfunded credit derivatives involve a contractual obligation for protection against credit events without creating a tradable instrument (e.g., CDS).
Why are credit derivatives used?§
Credit derivatives are used for hedging credit risk, diversifying credit exposure, and for speculation purposes.
How does a Credit Default Swap work?§
In a CDS, the protection buyer makes periodic payments to the protection seller. If the underlying entity defaults, the seller compensates the buyer, typically either by taking over the defaulted asset or providing a cash settlement.
Are credit derivatives risky?§
Yes, credit derivatives can be very risky due to their complexity and the potential for significant losses if the credit event occurs.
Related Terms§
- Derivative: A financial instrument whose value depends on the performance of an underlying asset.
- Underlying: The asset, index, or rate that determines the value of a derivative.
- Securitization: The process of pooling various types of debt and selling them as a consolidated financial product.
- Credit Default Swap (CDS): A contract where the protection seller agrees to compensate the protection buyer if the underlying entity defaults.
- Collateralized Debt Obligation (CDO): A complex structured finance product that pools various loans and debt instruments and issues new securities backed by the pooled assets.
Online References§
For further reading, these online resources can provide valuable insights into credit derivatives:
Suggested Books for Further Studies§
To delve deeper into the world of credit derivatives, consider the following books:
- “Credit Derivatives: Instruments, Applications and Pricing” by Geoff Chaplin
- “Credit Derivatives: Trading, Investing and Risk Management” by Geoff Chaplin
- “Credit Derivatives: A Primer on Credit Risk, Modeling, and Instruments” by George O. Aragon
- “The Handbook of Credit Derivatives” edited by Jack Clark Francis, Joy D. Thomas, and William W. Toy
Accounting Basics: “Credit Derivative” Fundamentals Quiz§
Thank you for diving into the detailed world of credit derivatives and challenging yourself with our quiz! Keep broadening your financial knowledge and expertise.
