What is a Credit Derivative?
A credit derivative is a financial instrument thats value is determined by the default risk of an underlying asset.
How Does a Credit Derivative Work?
Credit derivatives allow a lender or borrower to transfer the default risk of a loan to a third party. Though the terms differ from one credit derivative to another, the general procedure is for a lending party to enter into an agreement with a counterparty (usually another lender), who agrees, for a fee, to cover any losses incurred in the event that a the borrower defaults. If the borrower does not default, then the insuring counterparty pays nothing to the original lender and keeps the fee as a gain.
To illustrate, suppose XYZ Bank lends $10k to Bob over 10 years. Determining that Bob carries significant default risk as a borrower, XYZ Bank enters into a credit derivative with ABC Bank. The terms of the agreement state that in the event Bob defaults and is unable to repay the loan, ABC Bank will compensate XYZ Bank for the remaining interest and principal in return for an annual fee of $100 through the end of the 10-year term. If Bob does not default on the loan, ABC bank may keep the $100 annual fee as a gain.
Why Does a Credit Derivative Matter?
In essence, a credit derivative is an insurance policy against losses due to borrower default. In this respect, as with a credit default swap (CDS), it is important for both counterparties to agree on a fee that appropriately reflects the risk level associated with the third-party borrower.