John Kiff and Ron Morrow
Credit derivatives are swap, forward, and option contracts that transfer risk and return from one counter-party to another without actually transferring the ownership of the underlying assets. Similar products have been around for centuries and include letters of credit, government export credit and mortgage guarantees, private sector bond reinsurance, and spread locks.1 Credit derivatives differ from their predecessors because they are traded separately from the underlying assets; in contrast, the earlier products were contracts between an issuer and a guarantor. Credit derivatives are an ideal tool for lenders who want to reduce their exposure to a particular borrower but find themselves unwilling (say, for tax- or cost-related reasons) to sell outright their claims on that borrower.
The three major types of credit derivatives are default swaps, total-rate-of-return swaps, and credit-spread put options. These transactions can all be structured as derivatives contracts embedded in a more traditional on-balance-sheet structure, such as a credit-linked note.
Default swaps transfer the potential loss on a “reference asset” that can result from specific credit “events” such as default, bankruptcy, insolvency, and credit-rating downgrades. Marketable bonds are the most popular form of reference asset because of their price transparency. While bank loans have the potential to become the dominant form of reference ...