Suppose you manage a bank in Houston called Oil Drillers' Bank (ODB), which specializes in lending to a particular industry in your local area, oil drilling companies. Another bank, Potato Farmers Bank (PFB), specializes in lending to potato farmers in
Idaho. Both ODB and PFB have a problem because their loan portfolios are not sufficiently diversified. To protect ODB against a collapse in the oil market, which would result in defaults on most of its loans made to oil drillers, you could reach an agreement to have the loan payments on, say, $100 million worth of your loans to oil drillers paid to the PFB in exchange for PFB paying you the loan payments on $100 million of its loans to potato farmers. Such a transaction, in which risky payments on loans are swapped for each other, is called a credit swap. As a result of this swap, ODB and PFB have increased their diversification and lowered the overall risk of their loan portfolios because some of the loan payments to each bank are now coming from a different type of loans.
Another form of credit swap is, for arcane reasons, called a credit default swap, although it functions more like insurance. With a credit default swap, one party who wants to hedge credit risk pays a fixed payment on a regular basis, in return for a contingent payment that is triggered by a credit event such as the bankruptcy of a particular firm or the downgrading of the firm's credit rating by a credit-rating agency. For example, you could use a credit default swap to hedge the $1 million of General Motors bonds that you are holding by arranging to pay an annual fee of $1,000 in exchange for a payment of $10,000 if the GM bonds' credit rating is lowered. If a credit event happens and GM's bonds are downgraded so that their price falls, you will receive a payment that will offset some of the loss you suffer if you sell the bonds at this lower price.
Another type of credit derivative, the credit-linked note, is a combination of a bond and a credit option. Just like any corporate bond, the credit-linked note makes periodic coupon (interest) payments and a final payment of the face value of the bond at maturity. If a key financial variable specified in the note changes, however, the issuer of the note has the right (option) to lower the payments on the note. For example, General Motors could issue a credit-linked note that pays a 5% coupon rate, with the specification that if a national index of SUV sales falls by 10%, then GM has the right to lower the coupon rate by 2 percentage points to 3%. In this way, GM can lower its risk because when it is losing money as SUV sales fall, it can offset some of these losses by making smaller payments on its credit-linked notes.