Credit Derivatives & Risk Management

Risk management helps a firm prevent operating losses.

Risk management plays an important role in modern economies, especially in the operating activities of financial institutions, such as banks and insurance companies. Credit derivatives help organizations manage credit risk in business agreements.

Credit Derivative Defined

A credit derivative is a financial contract that helps business partners manage credit risk, according to financial information website Investopedia. Credit risk is the loss probability originating from a business partner's bankruptcy or inability to meet other financial commitments on time. Credit derivatives include financial assets, such as forwards and swaps.

Risk Management Defined

Risk management is a business practice that allows counterparties--also called business partners--to prevent operating losses in financial transactions. Risk management typically demands analytical dexterity, business acumen and mathematical savvy, according to Investopedia.

Correlation

Credit derivatives are distinct from risk management practices, but both concepts often interrelate. For example, a hedge-fund manager engages in a long-term credit transaction with a counterparty. The manager believes the counterparty's economic status is uncertain over the next 12 months. Accordingly, he purchases credit default swaps to mitigate the risk of default if the business partner files for bankruptcy within a year.

References

• Investopedia: Credit Derivative
• Investopedia: Credit Default Swaps: An Introduction
• Investopedia: Risk Management