Understand The Credit Derivatives Market

The credit derivatives market can be described as a bridge that exists between commercial banks and other types of financial establishments such as insurance companies or mutual fund companies.
By: James A Jackson
 
May 28, 2010 - PRLog -- The credit derivatives market can be described as a bridge that exists between commercial banks and other types of financial establishments such as insurance companies or mutual fund companies. According to Investopedia.com the definition of a credit derivative is, “privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk.” Credit derivatives are financial assets. Examples of these include forward contracts, swaps and an option for which the price inherent in is then is propelled by the credit risk of governments and/or private investors.

To give a concrete example of this, if a bank loans out money to a customer but then has reason to believe that the individual may not be able to repay the loan, it can protect itself from incurring any losses by taking the credit risk and transferring it to another party, while at the same time keeping the loan on its own books.

The credit derivative market boasted $40 billion in 1996 and has grown to an estimated $740 billion in a decade or more. This market has come to be accepted by all of the banks and financial institutions across the globe.

There is a high degree of risk involved in the credit market. That is why different risks need to be assessed for different types of credit and so do different types of protection. This market is broken down into three categories. There is credit default swaps, total rate of return swaps and equity default swaps.

In the case of credit default swaps, the buyer of the protection pays a premium to the seller of the protection. The debt or credit is not transferred to the seller until the events as stipulated in the contract take place.

When it comes to the total rate of return swap the parties involved in the swap together arrange for the transfer of the funds in the event that the underlying asset appreciates or depreciates. In this way the credit risk and the price risk are transferred.

The third type of credit derivatives market is the equity default swap. This is the newest category of the three. Both the protection seller as well as the protection buyer transfer funds at a particular event that is the net percentage increase or decrease of the asset. The equity default swap is debatable for some people. The question asked by these people is how is it possible for an equity to default?

The credit market can be difficult for those new to the financial markets to understand. To learn more about it do a search online for more in-depth information.    http://www.economywatch.com/finance/high-finance/credit-d...

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Source:James A Jackson
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