What are credit derivatives?

The following Banking & Finance practice note provides comprehensive and up to date legal information covering:

  • What are credit derivatives?
  • What is a credit derivative?
  • Funded or unfunded credit derivatives
  • Types of credit derivatives
  • Credit linked notes
  • Collateralised debt obligations
  • CPPI transactions
  • Credit default swap
  • Total return swap
  • Rationale for using credit derivatives
  • More...

What are credit derivatives?

What is a credit derivative?

A credit derivative is a bilateral transaction which takes its underlying value from the credit risk of a third party, known as the 'reference entity'. The reference entity issues reference obligations, which refer to its specific underlying direct and indirect (eg unguaranteed) obligations. The primary purpose of a credit derivative is to isolate the credit risk of that reference entity from all of its other risks. This reference entity can be a corporate, sovereign, municipality or a similar organisation and does not need to be a party to, or even aware of, the transaction. This ensures confidentiality for the parties entering the credit derivative transaction, as the reference entity may be a customer of one of the parties and so that party may not want that customer to be aware of the credit derivative transaction.

In its simplest form, a credit derivative is an over-the-counter transaction, meaning that the transaction is traded directly between two parties, without the use of an exchange.

The party assuming the credit risk of the reference entity is known as the 'protection seller' and the party acquiring the credit protection is known as the 'protection buyer'. If a Credit Event (as defined in the 2014 ISDA Credit Derivative Definitions) occurs on the underlying reference obligation, the payment obligations under the transaction will

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