The term credit derivative refers to an agreement that moves credit risk from one party to the other. Credit derivatives were originally used by participants in the banking industry to diversify the credit risk of customers in their lending portfolio.
The term derivative refers to any type of financial contract derived from another financial contract. Credit derivatives are financial agreements initially entered into by banks to move the risk associated with the financial agreements they established as lenders. Specifically, they would find a counterparty willing to assume the risk of non-payment on money they’ve lent customers.
Today, most credit derivatives take the form of credit default swaps or CDS. The seller of the CDS will compensate the buyer if one of the debtors goes into default on the loan. In this manner, the seller of the CDS insures repayment. In turn, the buyer of the CDS will make a series of payments to the seller. In this example, the seller of the CDS acts like an insurance company, and collects a fee for standing ready to pay the buyer of the CDS in the event the original issuer of the debt defaults on their loan. In exchange for the premium paid to the seller, the buyer of the CDS is protected from default on the debt instrument they hold.
CDS are especially important to investors looking to hold onto a bond until it matures. When first issued, a bond may carry with it repayment terms of ten years or more. While the company issuing the bond may be in sound financial condition at the time of purchase, that may not be the case in the future. It is this risk that is mitigated by this type of credit derivative.