Credit derivatives are financial contracts designed to transfer credit risk on loans and advances, investments and other assets/exposures from one party to another party. Transfer of credit risk may be for the whole life of the underlying asset or for a shorter period. The transfer may be for the entire amount of the underlying asset or for a part of it. A credit derivative may be referenced to a single entity or to a basket of several entities.

Thus, credit derivatives can be defined as arrangements that allow one party to transfer credit risk of a reference asset, which it may or may not own, to one or more other parties for a consideration, known as premium of fee.

The party who transfers the credit risk is named as protection buyer and the party who receives the credit risk is named as protection seller.

The credit derivatives could be resorted to for a variety of reasons. Some of them could include

- To reduce capital required to support credit risk exposures;

- To release credit exposure limits to a counter party;

- To reduce concentrations by shedding exposures to a counter party (without affecting the relationship with the borrower since there is no transfer of title of the asset) or to a sector;

- To assume exposures to a counter-party or to a sector to diversify risks or to fill gaps in credit quality spectrum

According to ISDA, International Swaps and Derivatives Association, the notional value of credit derivatives in 2006 was $34.6 trillion, an increase of 102% over 2005. It is roughly estimated that the credit derivatives market is around 6 times greater than the actual outstanding corporate debt (the underlying in the credit derivatives). This may imply that the majority of the credit derivatives are speculative.

Though credit derivatives are indeed an effective hedging tools, they are in the lime light these days for some other wrong reason – they are considered to be at the back (or forefront?) of the sub-prime crisis now affecting the global markets.

What are the reasons behind the current turmoil in the credit derivatives market? It is the view of the enlightened academics and research scholars that the speculative positions built up in this business are the main culprit leading to the following major risks and the resultant fallouts.

Credit risk – Credit risk in credit derivatives? Well. It is the counter party risk that owes on the trade. As the uncertainty increases, the protection seekers are forced to pay high premium or fee. Even though the risk premium goes up, still there is uncertainty with regard to the capability of the counter party to meet these obligations.

Leverage risk – One can look at the leverage effect two ways. First the credit derivatives built up over the underlying. As it is, it is around six times. This is one. Another could be the protection seeker who borrows to pay for the premium in a credit derivative transaction. This borrowing is again linked to the capacity to borrow and in turn linked to leverage. In case, the value of credit derivatives goes down in the market, it may trigger a margin call and the speculative protection buyer may find it difficult to meet this margin call.

Market risk – The price increase in CDS triggers the market risk and it can be fatal leading to bankruptcy filing of the protection seeker. He has to either bring in additional money to meet the margin call or he can now take up the role of a protection seller by selling credit derivatives to earn premium to meet the margin call.

Liquidity risk – As this vicious cycle engulfs the market, there may not be willing players to buy or provide protection putting off the genuine players from the market. And the lenders will become averse in the absence of a facilitating credit derivative market affecting the liquidity position of the lenders and borrowers

Legal risk – As with any other market, any trouble will only force the protection seeker or provider to look for a magnifying the finer prints in the credit derivative agreement to deny their obligations and this will lead to litigation.

Conflict of interest – Sometimes, the protection seeker or provider may be connected with the issuer of the underlying and they can play havoc in the market place with insider information. Such conflict of interest is cancerous to any growing and healthy market.

Modeling risk – The volatility in the credit derivative market, raises the risk of wrong pricing and this is directly the result of the models used. The underlying variables used to value the credit derivatives may not updated on a dynamic real time basis. This can lead to incorrect pricing and position marking.

Reputation risk – Any counter party who is on the wrong side of a credit derivative trade may lose his/her excellent credit rating and this possible down grade may affect the reputation.