Wednesday, May 6, 2009

credit derivative

credit derivative are a variety of instruments and techniques designed to separate and then transfer the credit risk of the underlying instruments such as loans or bonds.
They work on the principle that it is better to have a diversified portfolio of credit risks than a concentrated one where single risk exposures loom large.The concentration could be a single customer,industry or geographical group.Credit derivative products enable banks to trade and manage their overall credit risk exposure.
There are three major types of credit derivative:
*credit default swaps.
*derivatives based on credit spreads.
*total return credit swap
credit default swaps- the swap activates on the occurrence of a 'credit even'. This can be anything that affects the creditworthiness of a company such as insolvency,default on debt obligations or a ratings agency downgrading or a specified decline in the price of a reference security.
derivatives based on credit spreads- forwards,swaps and options based on the difference on the credit spreads available between,say,a corporate bond and the relevant comparable government bond. They will be triggered by,for example,the spread widening beyond a given spread level (indicating a deterioration in credit quality).
total return credit swap- these transfer both capital and interest between the seller and buyer.

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