credit derivative (CD)

Option or swap contract which serves as a hedge or insurance policy, and whose payoff depends on risk factors associated with a credit event (such as a firm's bankruptcy or changes in its prospects for bankruptcy). These derivatives separate specific factors of a credit risk (which may be managed) from the market risk (which may not be) and are used where a party's cost of managing a risk exceeds the cost of transferring it to another party. For example, bank-A transfers the risk of a customer's default (or a specified drop in its credit rating) through a contract to bank-B and pays a fee. If the default occurs (or the credit rating falls to that level) within the contract's duration, bank-B will compensate the bank-A up to the agreed-upon sum. Otherwise, bank-A gets nothing.