A credit derivative is a financial instrument that allows one party to transfer credit risk to another party without transferring the underlying asset. Essentially, credit derivatives are used to manage exposure to credit risk—in particular, the risk that a borrower will default on a loan or bond. Here are the key aspects of credit derivatives: 1. **Purpose**: They are used primarily for risk management, allowing investors and financial institutions to hedge against potential defaults or to speculate on changes in credit risk.
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A credit derivative transfers exposure to deterioration of credit quality or a specified credit event of a reference borrower without necessarily transferring the underlying loan or bond. Credit default swaps transfer a defined loss exposure; total return swaps transfer a wider asset return. Funded structures such as credit-linked notes combine the exposure with an investor's initial principal. Documentation specifies the reference entity, obligations, credit events and settlement; a hedge can leave counterparty credit risk and mismatch with the original exposure.