Credit derivatives
In finance, a credit derivative is a financial instrument or derivative whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded."[1] Credit default products are the most commonly traded credit derivative product[2] and include unfunded products such as credit default swaps and funded products such as synthetic CDOs (see further discussion below).
Credit derivatives in their simplest form are bilateral contracts between a buyer and seller under which the seller sells protection against certain pre-agreed events occurring in relation to a third party (usually a corporate or sovereign) known as a reference entity; which affect the creditworthiness of that reference entity. The reference entity will not (except in certain very limited circumstances) be a party to the credit derivatives contract, and will usually be unaware of the contract's existence.
Where credit protection is bought and sold between bilateral counterparties this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.
This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic CDOs; credit linked notes; single tranche CDOs, to name but a few. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk a ...