or swap contract
which serves as a hedge
or insurance policy
, and whose payoff
depends on risk
with a credit event
(such as a firm's bankruptcy
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.