GARP FRM Part 1 Practice Exam 2026 – Complete Prep Resource

A credit derivative is a financial contract that allows one party to transfer credit risk related to a specific asset or entity to another party. The primary purpose of a credit derivative is to enable investors to manage credit exposure without directly owning the underlying asset.

A credit default swap (CDS) is a prominent example of a credit derivative. In a CDS agreement, the buyer pays a periodic fee to the seller, and in return, the seller agrees to compensate the buyer in the event of a credit event, such as default, related to the reference entity. This mechanism allows the buyer to hedge against the risk of default, effectively transferring the credit risk to the seller.

The other options do not represent credit derivatives:

- A forward contract pertains to agreements to buy or sell an asset at a specified future date for a price determined today, focusing more on price risk rather than credit risk.

- An interest rate swap involves the exchange of interest payment streams, typically swapping fixed interest payments for floating ones. It is primarily concerned with interest rate risk rather than credit risk.

- An equity option gives the holder the right, but not the obligation, to buy or sell a stock at a predetermined price, focusing on equity market risk rather than credit risk.

Therefore, the identification of