What are credit derivative trades?

MJ · Tar Sands Joined: Feb 17, 2005 Posts: 77 Location: Belgium

I was watching the Closing bell at CNBC Europe last night, and besides the oil price being at record heights, they discussed an announcement which was made in the last hour of trading.
It was something of a special Fed meeting to discuss credit derivatives trades or something like that... I don't know what the hell those are, but they all seemed pretty excited and speculative about it. The only thing on which the reporter could elaborate was the complexity of this matter. Anyone can shine a light on this one?
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Two things are infinite: the universe and human stupidity; and I'm not sure about the universe.

nuhax · Tar Sands Joined: Jun 18, 2005 Posts: 62

Credit just means a debt security like Treasury or corporate bonds. Derivative just means an option contract that is traded, not the underlying bond itself.

http://en.wikipedia.org/wiki/Credit_derivatives

A Credit Derivative is a contract (derivative security) to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset. This is usually achieved by transferring risk on a credit reference asset. Early forms of credit derivative were financial guarantees. Some common forms of credit derivatives are total return swap, credit default swap and credit linked note.

aahala · Intermediate Crude Joined: Feb 03, 2005 Posts: 954

The credit derivative idea started when it became recognized that an
interest bearing investment had two parts - the principal part and the
interest part - and these parts could be traded individually.

Some US Treasury Bonds used to have coupons attached. When it
came time to receive semi-annual interest payments, the owner would
have to submit the coupon to Treasury. You could strip off all coupons
and sell the bond without the interest(at a discount from face value)
and retain the future interest payments, or vice versa.

The idea quickly developed to include other debt instruments, and thru
various evolutions, a credit derivative was just investing in the change
in future value, perhaps even on things that weren't securities at all, like
changes in the consumer price index.

The contracts can get so complex and obscure, virtually no one, including
the investors, can fully understand the potential financial consequences.