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Concept
Credit derivative
Summary
In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.
An unfunded credit derivative is one where credit protection is bought and sold between bilateral counterparties without the protection seller having to put up money upfront or at any given time during the life of the deal unless an event of default occurs. Usually these contracts are traded pursuant to an International Swaps and Derivatives Association (ISDA) master agreement. Most credit derivatives of this sort are credit default swaps. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.
This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic collateralized debt obligations (CDOs), credit-linked notes or single-tranche CDOs. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite.
The historical antecedents of trade credit insurance, which date back at least to the 1860s, also presaged credit derivatives more indirectly.
The market in credit derivatives as defined in today's terms started from nothing in 1993 after having been pioneered by J.P. Morgan's Peter Hancock. By 1996 there was around $40 billion of outstanding transactions, half of which involved the debt of developing countries.
Credit default products are the most commonly traded credit derivative product and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations (see further discussion below).
Official source
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