Credit derivative

[Anonymous]

In the second book of exam 1, a lot of credit derivative are described. I would like to confirm however what kind of credit are we hedging, is it the loans that the bank gives to her clients? And what exactly is hedged, is it the interest rates that the clients have on their loans, wether it´s fixed or variable rates? Thank you for your help!!

[varun]

credit derivatives are basically the protection which can be bought to protect return on your underlying investment. For instance you buy a bond which promises a certain amount of coupon for a certain maturity but there is a certain chance that the bond issuer might default , to overcome the same you can buy a credit derivative from an investment bank (or some other institution)by paying a certain premium which would give you a protection in the event the bond issuer defaults on its obligation.Obviously the institution which will sell the protection to you would have a view that the issuer will not default.
Think of it as if you buy an insurance for your car which gives you protection in an unforeseen event of your car being stolen or getting damaged the only difference being that you can buy a credit derivative on an underlying (bond) without actually owning the underlying but you cannot buy protection for your car without actually owning the car. Hope that helps.

[Anonymous]

It does help, thank you !! I was confused by the term “credit” derivative, I thought it had to be linked to a credit. Thanx again for your help!!

[Author]

Posts