Credit Derivatives

Derivative Products with payoffs that depend on risk factors related to credit quality, such as yield spread over Treasuries, price discount from par, or a "credit event." A credit event might be a drop in credit rating or some sort of failure, such as occurrence of default, insolvency or bankruptcy.

One goal of Credit Derivatives is to split credit risk from market risk. The key concept here is that credit risk is an undesirable element, akin to pollution. When you allow a market for pollution, people who don't want it sell it at at market price to the parties who mind it the least or handle it the best.

Credit Derivatives already come in a variety of flavors, and infinitely many types are possible. However, nearly all current structures are variations on Call or Put Options (q.v.) on Credit Spreads (q.v.), Binary Options (q.v.), or Knockout Options (q.v.). In the last two cases the trigger is a "credit event". Typically, the payoff depends on the state of the world some time – as much as months – after the event. Here are some examples of Credit Derivatives:
Notes that Bankers Trust and CSFP issued in 1993, which promised large coupons if the reference asset didn't suffer a "credit event" – namely, default or sufficient deterioration in its credit rating – and small coupons if it did. The spread of the large coupon over ordinary debt depended on the reference asset's credit quality, and was sometimes 80 - 100 b.p. (over LIBOR). This is a sort of Binary Option that is a function of the credit event.
A Binary Option that Bankers Trust offered, with a payoff that depended on the credit performance of a basket of bonds. If any of the bonds defaulted, then a counterparty paid Bankers Trust a fee.
A Call or Put Option on a credit spread over Treasuries.
A One-Touch (q.v.) Knockin Put (q.v.) Option on the value of a corporate bond.
A One-Touch (q.v.) Knockin Put Option (q.v.) on the lowest value of n corporate bonds in a portfolio.