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Credit derivatives’ payouts depend in some way on the creditworthiness of an organisation (which could be a sovereign state, a government body, a financial firm or a corporate). This creditworthiness is gauged by objective financial criteria or a third-party evaluation from a recognised credit rating agency, such as Moody’s Investors Service or Standard & Poor’s.
Credit derivatives might not appear to have an underlying in the conventional sense. But it is often argued that they are based on the cost of a credit event or, equivalently, the premium that would have to be paid to transfer the credit risk of a given transaction to a third party. Most importantly, these derivatives unbundle credit risk from other risks. For example, the holder of a floating-rate note issue can separate the credit risk (that the issuer will default) from the interest rate risk (that the coupon will fall).
There are two main types of credit derivative. The first, which includes credit default swaps (CDS) and put options, activates in the event of a credit event, such as a default or downgrade of debt. A second type of credit derivative is the credit spread forward or option. The underlying for these contracts is the spread between two otherwise identical securities, which depends only on the creditworthiness of the issuer. Swaps under which the total rate of return on an index is swapped for some reference rate are sometimes also referred to as credit derivatives.