Credit derivatives refer to bilateral contracts which are privately held. These contracts permit the holders to manage their credit risk exposure. Such derivatives turn out to be financial assets. Examples of the better-known ones in the derivatives universe are swaps, forward contracts, and options. The price of these is necessarily based upon the credit risk of economic entities like governments, companies, or private investors. This means that banks which are worried about one of their customers not being capable of repaying their loan are able to purchase protection against such a potential loss in default. They do this by keeping the loan on their books at the same time as they transfer the credit risk off to a third party more commonly referred to as the “counter party.”
Such credit derivatives are only one of numerous different kinds of financial instruments available to investors and financial institutions today. With these derivatives, they are merely instruments whose existence derives from underlying financial instruments. The value which underlies them comes from a stock or other asset.
Two different principal forms of derivatives exist. These are calls and puts. Calls provide the right but not obligation to purchase a stock for a pre-set price called the strike price. Puts deliver the right but not obligation to sell particular stocks for pre-arranged strike prices. With either calls or puts, investors are obtaining insurance in case a stock price rises or falls. This makes every form of derivative product an insurance vehicle and particularly these credit derivative examples.
Numerous credit derivatives exist on the markets today. Among these are CDO Collateralized Debt Obligations, CDS Credit Default Swamps, credit default swap options, total return swaps, and credit spread forwards. Banks are allowed to utilize these complicated instruments in order to completely take away their default risk from even an entire loan portfolio. The financial institutions or banks pay a premium, or upfront fee, for this accommodation.
Considering a concrete example helps to make the credit derivatives concept clearer. Plants R Us borrows $200,000 off of a bank with a ten year repayment term. Because Plants R Us shows a poor credit history, they are forced to buy the bank a credit derivative in order to be able to receive the loan. The bank accepts this product which will permit them to transfer all of the default risk to a third counter party. This means that the counter party would be forced to deliver all unpaid interest and principal on the loan in the event that Plants R Us defaults on the said loan. For this guarantee, Plants R Us pays an annual fee to the counter party for their assumed risk. Should the Plants R Us not default on the loan, then the counterparty firm keeps the entire fee. This makes it a win-win-win situation for all three parties. The bank is protected against a default by Plants R Us, which gets to have its loan. The counter party collects the yearly fee. All parties gain and benefit from the arrangement.
Credit derivatives’ values vary widely depending on several factors. These include the borrower’s credit quality as well as the counter party’s credit quality. The biggest concern comes down to the credit quality of the third party – counter party. If the counter party defaults or is otherwise unable to honor their commitments specified in the derivatives contract, then the financial institution will not get its payment for the loan principal and interest. The counter party would naturally no longer receive its annual premium payments any longer either. This is why the quality of credit for the counter party is so much more critical than is the credit quality of the borrower (Plants R Us in the example).