An Overview of Credit Derivatives

Abstract

Credit risk is the distribution of financial loss due to a broken financial agreement, for example failure to pay interest or principal on a loan or bond. It pervades virtually all financial transactions, and therefore plays a significant role in financial markets. A credit derivative is a security that allows investors to transfer credit risk to other investors who are willing to take it. By facilitating the distribution of risk, these instruments have an important economic function. Yet they have hit the headlines recently. This paper gives an overview of credit derivatives. It discusses the mechanics of standard contracts, describes their application, and highlights the mathematical challenges associated with their analysis.

Keywords: Credit derivatives, default correlation, collateralized debt obligation, portfolio credit risk, credit swap