According to financial theory, a credit derivative is a type of derivative or financial instrument the value and price of which is derived from the credit quality or trustworthiness of the liabilities of a third party traded in isolation. The most widely merchandised credit derivative products are the credit default products including products that are not funded, for example, credit default swaps, as well as funded products, for example, synthetic CDOs (Collateralized Debt Obligations).
In terms of simple explanation, the credit derivatives are two-sided agreements between a purchaser and seller in which the protection is sold for specific pre-accorded events that may occur in association to a third party (normally a sovereign or corporate) termed as a reference organization that influence the credit quality of the reference organization.
The reference organization usually does not become a party to the credit derivative agreement and does not have any idea about the presence of the agreement. Nevertheless, in specific circumstances, there are exceptions.
In case of credit derivatives, where the buying and selling of credit protection goes on between two parties, that is termed as unfunded credit derivative. In circumstances where the credit derivative gets into with the help of a special purpose vehicle or a financial services provider and the payments of the credit derivative are financed implementing the securitization methods, so that the SPV or financial services provider issues a debt obligation for backing these liabilities, then the entire procedure is termed as funded credit derivative.
Over the last 10 years or so, the procedure of synthetic securitization has acquired substantial popularity. The basic editions of these forms are called as credit linked notes, synthetic CDOs and single tranche CDOs.
In case of funded credit derivatives, the rating of the dealings is frequently performed by the credit rating agencies and this permits the investors to obtain separate shares of credit risk in accordance to their risk taking ability.
The credit derivatives can be broadly categorized into the following types:
Unfunded credit derivatives
Single name Credit default swap or CDS
Total return swap or TRS
Portfolio Credit Default Swap
First to Default Credit Default Swap
Credit Default Swap on Asset Backed Securities
Secured Loan Credit Default Swap
Recovery lock transaction
Credit default swaption or CDS
CDS index products
Constant Maturid Credit Default Swap or CMCDS
Credit Spread Option
Funded credit derivatives
Synthetic Collateralised Debt Obligation or CDO
Credit linked note or CLN
Synthetic Constant Proportion Portfolio Insurance or Synthetic CPPI
Constant Proportion Debt Obligation or CPDO