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A credit derivative is an
OTC
derivative designed to
transfer credit risk from one party
to another. By synthetically creating or eliminating
credit exposures,
they allow institutions to more effectively manage credit risks. Credit
derivatives take many forms. Three basic structures include:
 credit default swap: Two
parties enter into an agreement whereby one party pays the other a fixed
periodic coupon for the specified life of the agreement. The other party
makes no payments unless a specified credit event occurs. Credit events
are typically defined to include a material default, bankruptcy or debt
restructuring for a specified reference asset. If such a credit event
occurs, the party makes a payment to the first party, and the swap then
terminates. The size of the payment is usually linked to the decline in
the reference asset's market value following the credit event.
total return swap: Two
parties enter an agreement whereby they swap periodic payment over the
specified life of the agreement. One party makes payments based upon the
total return—coupons plus capital gains or losses—of a specified
reference asset. The other makes fixed or floating payments as with a
vanilla interest rate swap. Both parties' payments are based upon the
same notional amount. The reference asset can be almost any asset, index
or basket of assets.
credit linked note: A debt
instrument is bundled with an embedded credit derivative. In exchange
for a higher yield on the note, investors accept exposure to a specified
credit event. For example, a note might provide for
principal repayment
to be reduced below par in the event that a reference asset defaults
prior to the maturity of the note.
The fundamental difference between a credit default swap and a total
return swap is the fact that the credit default swap provides protection
against specific credit events. The total return swap provides protection
against loss of value irrespective of cause—a default, market sentiment
causing credit spreads to widen, etc.
Most credit derivatives entail two sources of credit exposure: one from
the reference asset and the other from possible default by the
counterparty to the transaction.
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