Credit derivatives allow banks to diversify their credit portfolios without venturing outside their usual clientele. For example, two banks, one specialising in farm sector credits, the other in industrial sector debt, may swap part of each other’s income streams. Both banks diversify their risks while each benefits from the other’s field of expertise.
Credit derivatives enable their buyers to protect themselves from the risk of counterparty default. Although methods for controlling and managing counterparty risk previously existed, credit derivatives make it possible to truly cut the risk level.
Lenders are not the only ones who use credit derivatives. Borrowers (e.g. bond issuers) may also use them to protect against potential market fluctuations which could result in a worsening of their financing terms.