Definition
Credit Derivative refers to a financial instrument whose value is derived from the credit risk associated with the underlying entity, typically in the form of debt obligations. The primary purpose is to transfer credit risk from one party to another without transferring the underlying asset.
There are two main types of credit derivatives:
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Unfunded Credit Derivative: A contract between two parties where the protection seller assumes the credit risk from the protection buyer in exchange for periodic payments. A common example is a Credit Default Swap (CDS).
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Funded Credit Derivative: A structured finance product where credit risk is packaged into tradable instruments, such as securities. One prominent example is a Collateralized Debt Obligation (CDO).
Examples
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Credit Default Swap (CDS): An unfunded arrangement where the protection seller compensates the buyer if the underlying entity defaults.
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Collateralized Debt Obligation (CDO): A funded instrument that pools various debt securities and then issues new tranches of securities with varying risks and returns.
Frequently Asked Questions (FAQs)
What is the primary difference between a funded and unfunded credit derivative?
Funded credit derivatives involve the creation of a financial instrument that is traded in the market, which pools and repackages credit risk (e.g., CDO). Unfunded credit derivatives involve a contractual obligation for protection against credit events without creating a tradable instrument (e.g., CDS).
Why are credit derivatives used?
Credit derivatives are used for hedging credit risk, diversifying credit exposure, and for speculation purposes.
How does a Credit Default Swap work?
In a CDS, the protection buyer makes periodic payments to the protection seller. If the underlying entity defaults, the seller compensates the buyer, typically either by taking over the defaulted asset or providing a cash settlement.
Are credit derivatives risky?
Yes, credit derivatives can be very risky due to their complexity and the potential for significant losses if the credit event occurs.
- Derivative: A financial instrument whose value depends on the performance of an underlying asset.
- Underlying: The asset, index, or rate that determines the value of a derivative.
- Securitization: The process of pooling various types of debt and selling them as a consolidated financial product.
- Credit Default Swap (CDS): A contract where the protection seller agrees to compensate the protection buyer if the underlying entity defaults.
- Collateralized Debt Obligation (CDO): A complex structured finance product that pools various loans and debt instruments and issues new securities backed by the pooled assets.
Online References
For further reading, these online resources can provide valuable insights into credit derivatives:
Suggested Books for Further Studies
To delve deeper into the world of credit derivatives, consider the following books:
- “Credit Derivatives: Instruments, Applications and Pricing” by Geoff Chaplin
- “Credit Derivatives: Trading, Investing and Risk Management” by Geoff Chaplin
- “Credit Derivatives: A Primer on Credit Risk, Modeling, and Instruments” by George O. Aragon
- “The Handbook of Credit Derivatives” edited by Jack Clark Francis, Joy D. Thomas, and William W. Toy
Accounting Basics: “Credit Derivative” Fundamentals Quiz
### What is an "unfunded credit derivative"?
- [x] A contract where the protection seller assumes credit risk in return for payments.
- [ ] A tradable instrument pooled using various debt securities.
- [ ] An equity instrument with underlying asset value.
- [ ] A derivative involving commodity exchange.
> **Explanation:** An unfunded credit derivative is a contract where the protection seller assumes the credit risk from the protection buyer without creating a tradable instrument, typical example is a Credit Default Swap (CDS).
### What is a "funded credit derivative"?
- [ ] A government bond with credit guarantees.
- [x] A structured finance product packaged as tradable securities.
- [ ] A derivative based on interest rate swaps.
- [ ] A risk-free investment.
> **Explanation:** A funded credit derivative involves the creation of securities from underlying credit risks, making them tradable, examples include Collateralized Debt Obligations (CDOs).
### Which of the following is an example of an unfunded credit derivative?
- [x] Credit Default Swap (CDS)
- [ ] Collateralized Debt Obligation (CDO)
- [ ] Mortgage-backed Security
- [ ] Treasury Bond
> **Explanation:** Credit Default Swaps (CDS) are unfunded credit derivatives, where the protection seller provides compensation to the buyer in case of default.
### How does a Credit Default Swap (CDS) provide protection?
- [ ] By pooling loans and issuing new securities.
- [x] By compensating the buyer if the underlying entity defaults.
- [ ] By increasing the interest rate.
- [ ] By transacting through equity swaps.
> **Explanation:** In a CDS, the protection seller compensates the buyer if the underlying entity defaults, thus providing protection against credit risk.
### What type of derivative is a Collateralized Debt Obligation (CDO)?
- [ ] Equity derivative
- [x] Funded credit derivative
- [ ] Unfunded credit derivative
- [ ] Currency derivative
> **Explanation:** CDOs are funded credit derivatives where underlying debt instruments are pooled and issued as new securities.
### What is one of the primary uses of credit derivatives?
- [ ] Only for speculative purposes.
- [ ] To eliminate all investment risks.
- [x] For hedging credit risk.
- [ ] To avoid regulatory requirements.
> **Explanation:** Credit derivatives are primarily used for hedging credit risk and managing exposure to credit events.
### In a credit derivative context, what does "underlying" refer to?
- [ ] The equity shares involved.
- [ ] The commodity prices associated.
- [x] The asset, index, or rate relative to which the derivative value is derived.
- [ ] The principal amount borrowed.
> **Explanation:** "Underlying" in credit derivatives refers to the asset, index, or rate that influences the derivative’s value.
### What must occur for a credit default swap to trigger a payment from the seller to the buyer?
- [ ] Increase in interest rates.
- [ ] Increase in equity prices.
- [x] Default of the underlying entity.
- [ ] Improvement in credit rating.
> **Explanation:** A default of the underlying entity must occur for the CDS protection seller to make a payment to the buyer.
### What are collateralized debt obligations (CDOs) primarily composed of?
- [ ] Equity shares
- [ ] Government bonds
- [ ] Commodities
- [x] Various underlying debt instruments
> **Explanation:** CDOs are composed primarily of various underlying debt instruments like loans, bonds, and other credit assets.
### Which statement best describes credit derivatives' primary risk?
- [ ] They entail no risk due to government backing.
- [x] They involve significant risk due to complexity and potential for large losses.
- [ ] They primarily involve market risk.
- [ ] They only involve negligible speculative risk.
> **Explanation:** Credit derivatives can be significantly risky due to their complexity and the potential for substantial losses if a credit event occurs.
Thank you for diving into the detailed world of credit derivatives and challenging yourself with our quiz! Keep broadening your financial knowledge and expertise.
