A credit derivative is a tool designed to transfer credit risk between two parties: a credit risk seller and a credit risk buyer. The former is interested in transferring the credit risk to another party in exchange for a premium (price of protection/ risk offload), while the latter is interested in receiving a premium for the protection against credit risk (inability of a debtor to fulfill contractual obligations). The credit risk buyer takes the credit risk instead of the seller according to specific conditions and for a specific period of time.

There are several types of credit derivatives, principally including:

• Credit default swaps (CDSs): the protection buyer pays a premium in return for the right to receive a conditional payment if a predetermined reference credit (asset/ entity/ obligation/ name) ends up in default. For the protection buyer (i.e., the risk seller), the contractual payments from the reference credit are the main concern. The amount of coverage or compensation is determined between the protection buyer and seller either prior to the default event or based on the observed prices of comparable obligations after a default.
• Credit-linked notes (CLNs): as structured note in which a credit derivative such as a CDS, is embedded. The purchase of a CLN bears the credit risk of the reference credit and an underlying collateral (some high-quality asset). In practice, a special purpose vehicle issues a CLN based on a reference entity’s credit risk. If the entity defaults, the note will no more be redeemable at par (100% of value), but the holders will receive below par percentage such as 70%.
• Total rate of return swaps (TRORSs): a swap which entails the exchange of the total return on a reference asset for a specific floating rate payment. In other words, the swap buyer will pay the total return on a bond in return for LIBOR and a spread. The total return of the bond consists of the bond’s coupon payment over its life in addition to any appreciation in its value over its life. The seller, in turn, will pay LIBOR plus a spread and any depreciation in the value of the bond. This swap is designed to provide protection against a deterioration of credit quality even if default does not occur.
• Credit spread options: an option that provides protection (in the form of a payout/ payoff) to the buyer when the spread between two underlying assets (say two fixed-income securities) widens to or beyond a specific extent. The buyer pays a premium for the protection and the seller pays compensation based on the spread.

Credit derivatives are also classified as: funded credit derivatives and unfunded credit derivatives. Funded credit derivatives include CLNs, collateralized debt obligations (CDOs), and constant proportion debt obligations (CPDOs). Unfunded credit derivatives encompass credit default swaps, credit spread options, credit default swaptions, etc.