A credit derivative is a financial contract between two parties that transfers the credit risk of a particular asset or portfolio of assets from one party to another. The common types of credit derivatives are credit default swaps (CDS), collateralized debt obligations (CDO) and credit-linked notes (CLN), and credit-linked notes (CLN).
Credit default swaps (CDS): A credit default swap is a type of credit derivatives that provides protection against a default of a particular credit asset. The buyer of a CDS pays a premium to the seller in exchange for a promise to receive a payment if the underlying credit asset defaults. For example, a hedge fund may purchase a CDS on a corporate bond to protect against the risk of default.
Collateralized debt obligations: A collateralized debt obligation is a type of credit derivative that pools together multiple credit assets, such as bonds or loans, and creates different classes of securities with varying levels of risk and return. Investors purchase these securities based on their risk and return preference. For example, a CDO may be created by pooling together a portfolio of mortgage-backed securities and creating different tranches of securities with varying levels of risk.
Credit-linked Notes (CLN): A credit-linked note is a type of credit derivative that is tied to the performance of a particular credit asset or portfolio of assets. The buyer of a CLN receives a return based on the performance of the underlying asset, but also assumes the credit risk associated with the asset. For example, an insurance company may issue a CLN that is tied to the performance of a particular corporate bond. If the bond defaults, the investor in the CLN will lose money.
Overall, credit derivatives are used by investors to
manage their exposure to credit risk and to create investment opportunities
based on the performance of credit assets. However, credit derivatives can also
be complex and risky financial instruments that require a deeper understanding
of credit risk and financial markets.