Credit Default Contract

DEFINITION of 'Credit Default Contract'

Security with a risk level and pricing based on the risk of credit default by one or more underlying security issuers. Credit default contracts include credit default swaps (CDSs), credit default index contracts, credit default options and credit default basket options. Credit default contracts are also used as part of the mechanism behind many collateralized debt obligations (CDOs); in these cases, the contracts may have unique covenants that exclude company events, such as a debt restructuring as a "credit event".

BREAKING DOWN 'Credit Default Contract'

The main goal of credit default contracts is to establish a price for a given default risk, where it can then be traded to another party who wishes to accept it. Growth of credit default contracts has exploded in recent years, as liquidity has grown along with institutional investor interest. They are a versatile tool for transferring risk away from a lender's balance sheet (such as in CDS) or for pure speculation by hedge funds and other investment vehicles.

The biggest risk in credit default contracts is their extreme sensitivity to individual company and market fluctuations. If fear of default starts to creep into the credit default markets, spreads will rise across the board, making the cost of protection that much more expensive, and slowing down activity in the debt markets as a whole.