Refer to the Steel company case again. Bank A would extend a $1 million loan to the Steel Company. At same time Bank A issues to institutional investors an equal principal amount of a credit-linked note, whose value is tied to the value of the loan. If a credit event occurs, Bank A’s repayment obligation on the note will decrease by just enough to offset its loss on the loan.
An investor may purchase from an insurer an option to sell a bond at a particular spread above LIBOR Credit spread. If the spread is higher on the exercise date, then the option will be exercised. Otherwise it will lapse.
FIM - Credit Derivatives PPT
Credit Derivatives in India 11EX-013 Bishnu Kumar 11EX-015 Davinder Singh 11EX-040 Prateek Wadhwa 11EX-041 Priyanka Tyagi
Content• Credit Derivatives• Credit Default Swaps• Credit Derivatives Market in India• CDS & its Settlement in India• Role of CCIL• First CDS in India
Credit DerivativesCredit derivatives are derivative instruments that seek to trade in credit risks. • Derivative is a financial contract that has its price derived from, and depending upon, the price of an underlying asset. • The risk that a counterparty to a financial transaction will fail to fulfill their obligation.
Types of Credit Derivatives• Credit Default Swaps (CDS)• Credit Link Notes (CLN)• Credit Spread Options (CSO)
Credit Default Swap• A huge market with over $40 trillion of notional principal• Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity)• Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year protection against company X• Premium is known as the credit default spread. It is paid for life of contract or until default• If there is a default, the buyer has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds are typically deliverable)
Pictorial Representation Credit Risk Premium Fee Insurance Company C Bank A Buyer Contingent Payment On Seller Credit Event Steel company Reference Asset
Credit Linked Notes• A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the note issuer to the investor.• The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral.• If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity’s debt
Pictorial Representation $1 Million Bank A Institutional investors fixed or floating coupon,if defaults or $1million declares bankruptcy the investors receive an 500b p amount equal to the recovery rate Steel Company Steel Company
Credit Spread Options• A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the note issuer to the investor.• The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral.• If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity’s debt
Credit Derivative Market in India (1/2) Considered to be an inefficient Market • Banks & Financial Institutes have mostly Loans and Little Bonds in their portfolio • Mutual funds, insurance companies, pension funds and hedge funds have mostly bonds in their portfolios With little access to loans, depriving them of high returns of loans portfolios • Market in the past did not provide the necessary credit risk protection to banks and financial institutions. • Neither did it provide any mechanism to the mutual funds, insurance companies, pension funds and hedge funds to have an access to loan market to diversify their risks and earn better return.
Credit Derivative Market in India (2/2) Benefits from Credit Derivatives • Credit derivatives allow banks to transfer credit risk and hence free up capital, which can be used in productive opportunities. • Banks can conduct business on existing client relationships in excess of exposure norms and transfer away the risks. • Banks can construct and manage a credit risk portfolio of their own choice and risk appetite unconstrained by funds, distribution and sales effort. Banks can acquire exposure to, and returns on, an asset or a portfolio of assets by simply writing a credit protection. • Credit risk would be diversified – from banks/FIs alone to other players in the financial markets and lead to financial stability • It provides better liquidity than the existing mechanisms of managing the risks like insurance, guarantee, securitization, etc.
CDS & its settlement in India• The CDS market will be an OTC market in India which means the deals between the protection buyer and the protection seller will be bilateral deals making them do the negotiation and pricing for the CDS contracts.• In the infancy stage of CDS market in India one can have a trade reporting platform which will be gathering all the information about the trades happening. This will provide the required transparency and help in gaining the confidence in the product.• Once the market matures one can think of having an electronic order matching platform with central counterparty settlement (like CCIL).
Role of CCIL (Clearing Corporation of India)• Improve efficiency in the transaction settlement process• Insulate the financial system from shocks emanating from operations related issues• To undertake other related activities that would help to broaden and deepen the Money, Gilts and Forex markets in India• It provides settlement of three different products under one umbrella• Guaranteed settlement of IRS which will involve • Trade matching • Initial and MTM margining • Exposure check • Novation • Multilateral Netting • Default handling
First Credit Default Swap in India • The first credit-default-swap trades offering protection on Indian corporate bonds were completed on Dec 7, 2011, according to separate statements from Indias IDBI Bank and ICICI Bank. • IDBI said it underwrote one CDS transaction and ICICI said it was responsible for another. The combined trade sizes totalled $1.9 million, according to the Clearing Corporation of India, Ltd., and comprised a pair of trades each worth 50 million rupees. • The protection was sold on bonds issued by Indias Rural Electrification Corp. Ltd., a lender to the power sector, and Indian Railway Finance Corp. Ltd. • The buyers of protection paid 90 basis points. One basis point translates to $1,000 a year on a derivatives contract used to protect $10 million of debt against default for five years.