What are credit derivatives?

Credit derivatives permit the transfer of credit exposure between parties, in isolation
from other forms of risk. Banks can use credit derivatives both to assume or
reduce (hedge) credit risk. Market participants refer to credit hedgers as protection
purchasers, and to providers of credit protection (i.e. the party who assumes credit
risk) as protection sellers.
There are a number of reasons market participants have found credit derivatives
attractive. First, credit derivatives allow banks to customize the credit exposure
desired, without having a direct relationship with a particular client, or that client
having a current funding need. Consider a bank that would like to acquire a twoyear
exposure to a company in the steel industry. The company has corporate debt
outstanding, but its maturity exceeds two years. The bank can simply sell protection
for two years, creating an exposure that does not exist in the cash market. However,
the flexibility to customize credit terms also bears an associated cost. The credit
derivative is less liquid than an originated, directly negotiated, cash market exposure.
Additionally, a protection seller may use only publicly available information in
determining whether to sell protection. In contrast, banks extending credit directly to
a borrower typically have some access to the entity’s nonpublic financial information.
Credit derivatives allow a bank to transfer credit risk without adversely impacting
the customer relationship. The ability to sell the risk, but not the asset itself, allows
banks to separate the origination and portfolio decisions. Credit derivatives therefore
permit banks to hedge the concentrated credit exposures that large corporate relationships,
or industry concentrations created because of market niches, can often
present. For example, banks may hedge existing exposures in order to provide
capacity to extend additional credit without breaching internal, in-house limits.
There are three principal types of credit derivative products: credit default swaps,
total return swaps, and credit-linked notes. A fourth product, credit spread options,
is not a significant product in the US bank market.