What is the definition of Credit Derivatives?

A Credit Derivative is a special kind of derivative agreement that enables a company to manage its credit risk. To do that, the company can transfer credit risk to other parties by selling all or a portion of the credit risks.

Credit Derivatives can be used to give legal entities with methods on how to decrease credit exposure brought about by loan default, bankruptcy or foreclosure.

For example, Bank 1 things that it has a high level of high-risk installment loans that it has given to a number of customers. Bank 1 can then go into a credit derivatives agreement with Bank 2. With this, all or a portion of the credit risk is accepted by Bank 2. Bank 2 will bear the risk of the loans for a fee that will be given by Bank 1. The loans are still listed in the balance sheet of Bank 1 but Bank 2 will retain the credit.

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