Credit derivative (CD)

A credit derivative is a financial instrument that takes its value from that of the credit risk on bond or loan. It is considered a securitized derivative.

A derivative is simply an instrument or contract whose value depends on the asset it is associated with. Any changes in the price of the asset will affect the value of the derivative. The assets themselves contain the value, as derivatives do not inherently possess value.

In the case of a credit derivative, the buyer and seller agree on the sale of credit risk protection. As such, the credit risk is on a reference entity, and not on either of the two parties involved in the agreement.

In a way, a credit derivative acts as a kind of bet between the two parties in the agreement. The buyer of the credit derivative may not be the owner of the reference entity or bond, but he may think that it will go into default. Should this happen, the buyer is able to make a huge profit. However, due to the nature of the agreement, it may seem to be a very risky investment strategy.

In order for the buyer to profit from the purchase of a credit derivative, the reference entity should be unable to pay his obligations or declare bankruptcy. In case of obligation acceleration, in which a bond becomes immediately due and the obligation of the reference entity is set at a much earlier date, the buyer also stands to benefit.

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