By synthetically creating or eliminating credit exposures, they allow institutions to more effectively manage credit risks.
Credit derivatives take many forms.
The other party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and the swap then terminates. The size of the payment is usually linked to the decline in the reference asset's market value following the credit event. Two parties enter an agreement whereby they swap periodic payment over the specified life of the agreement.