Handbook of Finance: Financial Markets and Instruments

Chapter 42. Introduction to Credit Derivatives

VINOD KOTHARI

Independent financial consultant and Visiting Faculty, Indian Institute of Management, Kolkata, India

Abstract: Credit derivatives are devices that provide for trading in generic credit risk of an entity, asset, or bunch of entities or bunch of assets. Credit risk is the risk inherent in credit, and credit is the very basis of our present society. Credit derivatives were first introduced in the early 1990s and are part of the market for financial derivatives. Since credit derivatives are presently not traded on any of the organized exchanges, they are a part of the over-the-counter (OTC) derivatives market. Credit derivatives include credit default swaps, total return swap, credit-linked notes, and credit spread options, as well as the fast-growing world of portfolio synthetic trades structured either as bespoke collateralized debt obligations (CDOs) or as index trades referenced to baskets of entities or asset-backed securities. Though still a relatively small part of the huge market for OTC derivatives, credit derivatives are growing faster than any other OTC derivative.

Keywords: credit derivatives, credit asset, reference entity, reference obligation, reference asset, reference portfolio, protection buyer, protection seller, risk seller, risk buyer, credit events, premium, deliverable obligations, protection payments, credit event payments, physical settlement, cash settlement, synthetic asset, unfunded asset, single ...