Credit Derivatives

Derivatives are not only limited to stock market or commodity market, credit derivative is another example of why derivatives are being used by the people. Derivative can be defined as a contract or an agreement for exchange of payments, whose value is derived from the value of an underlying asset. In case of credit derivative the value of derivative is derived from credit risk on an underlying bond, loan or any other debt. In a credit derivative the asset on which credit is taken remains with the owner and the volatility associated with such asset is transferred to the party which is taking the derivative. The owner continues to hold the underlying asset without risk or volatility. It is the lender who takes the credit derivative in order to hedge against risks that comes with loans or debts.

Credit derivative covers the risk which arises when the party which has taken the credit becomes bankrupt or the borrower does not pay the obligation on time to the lender of the money; borrower pays only half or notional amount due to bankruptcy and other such risks. The lender will have to pay premium in order to transfer the all the above risks. The counterparty will benefit if the borrower pays the money on time because he or she will receive premium. In other words premium represents the reward for the counterparty.

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