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 most common types of credit derivatives are credit default swaps
(CDS), collateralized debt obligations (CDO), and credit-linked notes (CLN).
1. Credit default swaps (CDS): A credit
default swap is a type of credit derivative that provides protection against
the 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.
2.
Collateralized debt obligations (CDO):
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 preferences. 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.
3.
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 deep understanding of credit risk and financial
markets.