Credit Derivatives Kajal Udas

A credit derivative is a financial instrument that’s value is determined by the default risk of an underlying asset. Credit derivatives are also used to transfer credit risk of loans and other assets. Option, forward and swaps are basic structure of credit derivative.

Credit derivatives allow a lender or borrower to transfer the default risk of a loan to a third party. Though the terms differ from one credit derivative to another, the general procedure is for a lending party to enter into an agreement with a counterparty (usually another lender), who agrees, for a fee, to cover any losses incurred in the event that a the borrower defaults. If the borrower does not default, then the insuring counterparty pays nothing to the original lender and keeps the fee as a gain.

Securitization The term securitization refers to the transformation of illiquid, non-marketed assets into liquid, marketable assets, i.e. securities. Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing.