Credit derivatives are among the most recent financial innovations in the banking industry. By allowing banks to sell or buy the credit risk on a loan or a portfolio of loans, they separate the funding of loans from the holding of credit risk.
Credit derivatives are a form of credit insurance. Consider the case of Alpha Bank, which has funded a loan to corporate client ABC. Alpha Bank is willing to fund the loan and keep it on its balance sheet, but it does not want to face the credit risk, that is, the losses that could result from a default by its corporate client. Therefore, Alpha Bank will search for a counterparty—this ...