A credit derivative is a financial instrument for which the value is derived from the credit risk on an underlying financial asset. These are bilateral contracts between a buyer and seller under which the seller sells protection to the buyer against the credit risk of the underlying asset.
A credit event is an event which gives the protection buyer the right to settle a credit derivative with the protection seller. As per ISDA (International Swaps and Derivatives Association) standards, some widely used credit events are – Bankruptcy, Failure to Pay, Restructuring, Obligation Acceleration etc.
Examples of key Credit Derivatives are:
PAUG SWAP: PAUG stands for “Pay as you go”. In PAUG Swap, two counterparties exchange get into a swap transaction where payment is based on current status or protection seller makes cash payments to the protection buyer for any write-downs or credit loss on the investment during the lifetime of the Swap.
Total Return Swap: In total return swap, one party pays based on the total return of the underlying asset where the other party pays as per pre-determined fixed or market floating rates. Total return include both income and capital gains.
CDS: Credit Default Swap is the most widely used/traded credit derivatives in the financial market an investor buys protection (or Insurance) from a protection seller to protect the investment from any default risk for which buyer pays premium to the protection seller. If the counterparty defaults on payment, then the protection seller pays the loss amount.
Use of Credit Derivatives:
Used to transfer credit risk between the two counterparties
Used to hedge or mitigate default and other risks involved in an investment
Used as an alternative to Equity Derivatives or loan or bond investments