The RBI has released new circular on Credit Derivatives. Understand what is credit derivative and download pdf of official circular.
What is the Credit Derivatives Market?
The Credit Derivatives Market is a financial market where banks and financial institutions buy and sell protection against the risk of loan or bond defaults. In simple words, it allows a bank to transfer the risk of a loan to another party without selling the loan itself.
Simple Example
Suppose a bank gives a loan of ₹100 crore to a company. The bank is worried that the company may not repay the loan. The bank enters into a credit derivative contract with another financial institution. The bank pays a small fee to the other institution. If the company repays the loan, the other institution keeps the fee. If the company fails to repay the loan, the other institution bears the loss as per the contract. This helps the bank reduce its credit risk.
Why is the Credit Derivatives Market Important?
The Credit Derivatives Market helps banks and financial institutions:
- Reduce the risk of loan defaults.
- Manage their loan portfolio better.
- Protect themselves from financial losses.
- Free up funds to give more loans.
Main Credit Derivative
The most common credit derivative is the Credit Default Swap (CDS). It provides protection against the default of a loan or bond. In India, the Reserve Bank of India (RBI) regulates the Credit Derivatives Market and issues guidelines for its operation.
Click here to download RBI circular on Credit Derivatives
