Knowing The Basics Of Credit Derivatives

by : David Gass

Securities and derivatives are the two most important financial developments of our times. Credit derivatives evolved as an extension of these two. The word derivative is befitting because it is a contract that itself derives from a contract. A typical example is derivative in stock market, which is a contract that does not require buyer to own the concerned stocks. Instead, the fluctuation in stock price is the key factor that decides how the contract will be settled. In exactly same manner, credit derivatives do not require the buyer to own the asset in question. The settlement of the contract takes place by taking into account the returns from that particular asset.

Risks And ReturnsCredit derivatives are full of both risks and rewards. People buy a credit derivative, because they feel that they will gain something out of the deal. If everything goes right, the buyer gets the rewards. On the other hand, if things do not go according to the expectations then the buyer suffers losses.

Reasons For Bad ResultsKnowledge about the basics of credit derivatives also keeps people informed about unexpected results. Some of the reasons for loss of money are default, losses, delinquency, prepayment, foreclosure, movement in exchange rates, and the fluctuating interest rates. The purpose of a credit derivative contract is to transfer the things involved in a transaction to the other person or company while the ownership of the asset remains intact as it was.

Types of DerivativesThere are many types of credit derivatives. Below are descriptions of two of the most popular.

1. Total return swap: As the name indicates this is an exchange of a total return from a credit asset with a pre-decided return in the contact. Changes in interest rates and exchange rates and many other factors collectively affect the total returns from the asset in question.

2. Credit default swap: This is a modern version of the age-old financial guarantee. However, credit default swap covers some additional things such as apprehended default and downgrading.

A Final ThoughtA thorough understanding of the basics of credit derivatives makes it clear that it is not a bad idea to start trading in derivatives. Because you do not enter into any agreement regarding purchasing the asset, your risk is limited only to the performance of the asset. However, the possibility of losing the money is always there even if the risk involved is much less than with other alternatives.