Credit derivatives are a group of innovative products that offer a new way to separate credit risk from an underlying financial instrument.

Formally, they are bilateral financial contracts that isolate specific aspects of credit risk from an underlying instrument and transfer it. To risk managers, they are a flexible tool to restructure credit portfolios. To institutional investors, they are a new asset class that can be engineered to meet varying demands.

It is little wonder that the marketplace for credit derivatives is expanding rapidly. Second-and third-generation products are emerging even before names and vocabulary for the first generation are standardized.

Here are a few of the basic, rudimentary concepts, intended to provide a non-technical introduction.

The Credit Swap as a Prototype One of the most basic credit derivatives is a Credit Swap, also known in some circles as a Credit Default Swap. In this transaction, one party, ordinarily called the Protection Buyer, makes a periodic payment in return for a payment by the other party, called the Protection Seller, that is contingent on the occurrence of some agreed-upon event relating to an underlying credit. A simple example might have a Buyer, who holds a public security of Corporation X, paying a monthly fee to the Seller. The Seller has an obligation to make a pre-determined payment to the Buyer, but that obligation arises only in the event of Corporation X being declared insolvent. The flexibility is clear when one understands that the terms can be negotiated between the parties and can relate to aspects other than the fees and payments. For example, the "event" triggering the payment might be the downgrading of a credit rating, a restructuring of Corporation X's debt, and so forth to whatever level of specificity or complexity is agreed upon.

Thanks to J.P. Morgan & Co. Incorporated for providing material and assistance for this piece; with particular appreciation to Don Thompson, Vice President and Assistant General Counsel.