Credit derivatives

        A credit derivative is simply a financial instrument that allows one to assume or cede credit risk exposure. Credit derivatives can be based on corporate debt, government debt, residential or commercial real estate mortgages, or other types of loans.

        Credit risk is transferred with a traded insurance-like contract between two parties, neither of which need be the issuer nor the holder of the actual bonds or loans at risk. The value of the contract is “derived” primarily as a function of the default risk profile of the debtor, which leads to the term, credit “derivative.”

Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives.

An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract, i.e. payments of premiums and any cash or physical settlement amount itself without recourse to other assets.

A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. The protection buyer, however, still may be exposed to the credit risk of the protection seller itself. This is known as counterparty risk.