Credit Derivatives are over the counter financial contracts. They are usually defined as “off-balance sheet financial instruments that permit one party to transfer credit risk of a reference asset, which it owns, to another party without actually selling the asset”. It, therefore, “unbundles” credit risk from the credit instrument and trades it separately. Credit Linked Notes (CLNs), another form of credit derivative product, also achieves the same purpose, though CLNs are on-balance sheet products. Another way of describing credit derivative is that it is a financial contract outlining potential exchange of payments in which at least one leg of the cash flow is linked to the “performance” of a specified underlying credit sensitive asset.
Protection Seller refers to the party that contracts to receive premiums or interest-related payments in return for assuming the credit risk on an asset or group of assets from the Protection Buyer. The Protection Seller is also known in the market as the Credit Risk Buyer or Guarantor.
Where a Protection Seller has sold protection through a CDS it acquires credit exposure to the Reference Asset. This exposure is to be risk-weighted according to the risk weight of the Reference Asset.
Protection Buyer refers to the party that contracts to transfer the credit risk on an asset or group of assets to the Protection Seller. The Protection Buyer is also known in the market as the Credit Risk Seller or Beneficiary.
Where an asset is protected by a credit default swap (CDS), the Protection Buyer may replace the risk weight of the underlying asset with that of the Protection Seller to the extent of amount of protection as determined for this purpose.
Premium, is the fee the protection buyer pays to the protection seller as in case of insurance business.
Credit event is defined as a scenario or condition agreed between the contracting parties that will trigger the credit event payment from the Protection Seller to the Protection Buyer. Credit events usually include bankruptcy, insolvency, merger, cross acceleration, cross default, failure to pay, repudiation, and restructuring, delinquency, price decline or rating downgrade of the underlying asset / issuer.