Credit derivatives: CDS, TRS, CSO, CLN and CDO

Credit derivatives are the most recent group of instruments for managing (reducing or eliminating) credit risk exposures. They have occurred as a result of financial institutions' demand for a credit risk hedging and diversification instrument. They enable their users to separate credit risk from market risk, i.e. to transfer credit risk, when conducting a transaction. Credit derivatives play an extremely important and controversial role on the financial markets. They have transformed the way in which financial institutions monitor, hedge and manage credit risk, because they have enabled its efficient, flexible and simple transfer. The risks entailed by credit derivatives are mostly related to the fact that the credit derivatives market is new and insufficiently explored. When used properly, credit derivatives are a means for establishing financial stability. In order to provide a better understanding of credit derivatives, this paper elaborates on the main characteristics, mechanisms of functioning, implementation, advantages and disadvantages of the main types of credit derivatives: credit default swaps, total return swaps, credit spread options, credit-linked notes, and collateralized debt obligations.