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Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
Fim project credit derivatives in india
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Fim project credit derivatives in india

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  • 1. Credit Derivatives 11EX-013 Bishnu Kumar 11EX-015 Davinder Singh 11EX-040 Prateek Wadhwa 11EX-041 Priyanka Tyagi Institute of Management Technology Ghaziabad
  • 2. Credit DerivativesTable of ContentsCredit Derivatives .............................................................................................................................................. 2 A definition of Credit Derivative .................................................................................................................... 2 Types of Credit Derivatives ............................................................................................................................ 2 Risks of Credit Derivatives ............................................................................................................................. 3 Growth of Credit Derivatives ......................................................................................................................... 4Credit Default Swaps ......................................................................................................................................... 5 Types of Credit Default Swaps ....................................................................................................................... 8 Settlement methods for CDS ......................................................................................................................... 9 Uses of Credit Default Swaps ........................................................................................................................ 9 CDS Pricing ................................................................................................................................................... 12Credit Derivatives Market in India ................................................................................................................... 12 Benefits from Credit Derivatives ................................................................................................................. 13 Participants in the Indian Market ................................................................................................................ 13 Minimum Conditions ................................................................................................................................... 13 Draft CDS Guidelines ................................................................................................................................... 14 Participants allowed .................................................................................................................................... 14CDS & its settlement in India ........................................................................................................................... 16Role of CCIL ...................................................................................................................................................... 17First Credit Default Swap in India .................................................................................................................... 18References………………………………………………………………………………………………………………………………………………….19 Institute of Management Technology, Ghaziabad 1
  • 3. Credit DerivativesCredit Derivatives The development of credit derivatives is a logical extension of the ever-growingarray of derivatives trading in the market. The concept of a derivative is to create acontract that transfers some risk or some volatility. Credit derivatives apply the samenotion to a credit asset. Credit asset is the asset that a provider of credit creates, suchas a loan given by a bank, or a bond held by a capital market participant. A creditderivative enables the stripping of the loan or the bond, from the risk of default, suchthat the loan or the bond can continue to be held by the originator or holder thereof,but the risk gets transferred to the counterparty. The counterparty buys the riskobviously for a premium, and the premium represents the rewards of thecounterparty. Thus, credit derivatives essentially use the derivatives format to acquireor shift risks and rewards in credit assets, viz., loans or bonds, to other financialmarket participants.A definition of Credit Derivative Credit derivatives can be defined as arrangements that allow one party (protectionbuyer or originator) to transfer, for a premium, the defined credit risk, or all the creditrisk, computed with reference to a notional value, of a reference asset or assets,which it may or may not own, to one or more other parties (the protection sellers). So here the protection buyer continues to hold the reference asset (loan or bond)and protection seller holds the risk associated with the asset (loan or bond) also calledas holding synthetic asset. The protection seller holds the risk of default, losses,foreclosure, delinquency, prepayment, etc. and the reward of premium. There couldbe two possible ways of settlement in case of credit event. In first case, physicalsettlement, protection seller gives the par value of asset to the protection buyer andprotection buyer hands over the asset to the protection seller. Whereas in secondcase, cash settlement the difference between the par value of the asset and themarket value of the asset is given by protection seller to the protection buyer.Types of Credit Derivatives Some of the fundamental types of credit derivatives are credit default swap, totalreturn swap, credit linked notes, and credit spread options. Credit Default Swaps: A credit default swap (CDS) is a credit derivative contractbetween two counterparties. The buyer makes periodic payments to the seller, and inreturn receives a payoff if an underlying financial instrument defaults. Credit defaultswaps are the most important type of credit derivatives in use in the market. Total Return Swaps: As the name implies, a total return swap is a swap of thetotal return out of a credit asset swapped against a contracted prefixed return. Thetotal return out of a credit asset is reflected by the actual stream of cash-flows fromthe reference asset as also the actual appreciation/depreciation in its price over time,and can be affected by various factors, some of which may be quite extraneous to theasset in question, such as interest rate movements. Nevertheless, the protectionseller here guarantees a prefixed spread to the protection buyer, who in turn, agreesto pass on the actual collections and actual variations in prices on the credit asset to Institute of Management Technology, Ghaziabad 2
  • 4. Credit Derivativesthe protection seller. Total Return Swap is also known as Total Rate of Return Swap(TRORS). Credit Linked Notes: It is a security with an embedded credit default swapallowing the issuer (protection buyer) to transfer a specific credit risk to creditinvestors. CLNs are created through a Special Purpose Vehicle (SPV), or trust, which iscollateralized with securities. Investors buy securities from a trust that pays a fixed orfloating coupon during the life of the note. At maturity, the investors receive parunless the referenced credit defaults or declares bankruptcy, in which case theyreceive an amount equal to the recovery rate. The trust enters into a default swapwith a deal arranger. In case of default, the trust pays the dealer par minus therecovery rate in exchange for an annual fee which is passed on to the investors in theform of a higher yield on the notes. Credit Spread Options: A financial derivative contract that transfers credit riskfrom one party to another. A premium is paid by the buyer in exchange for potentialcash flows if a given credit spread changes from its current level. The buyer of creditspread put option hopes that credit spread will widen and credit spread call buyerhopes for narrowing of credit spread. It can be viewed as similar to that of creditdefault swaps but it hedges also against credit deterioration along with default.Consider the buyer of credit spread put: he/she pays a premium for the put. If thebond (the reference entity) deteriorates, the spread on the bond will increase and thebuyer will profit. But if the bond quality increases, the credit spread will narrow, bondprice will decrease, and the put will be worthless (i.e., put buyer has lost thepremium). In summary, the credit spread put buyer wants to hedge against pricedeterioration and/or default risk of the obligation. The payoff is - Duration (D) x Notional (N) x [credit spread (-) strike spread; CS - K].Risks of Credit Derivatives Various risks associated with credit derivatives are credit risk, market risk, andlegal risk. Credit Risk: The protection seller is having a credit risk related to underlyingreference asset because protection seller synthetically holds the asset and needs to dodue diligence to counter this risk. Another risk is associated is counterparty riskagainst protection seller if he fails to make good of his obligations. Market Risk: Market risk is associated with credit derivatives traders as the pricesof the instruments are a function of interest rates, the shape of the yield curve, and Institute of Management Technology, Ghaziabad 3
  • 5. Credit Derivativescredit spread. Other types of risks involved are marking to market risk, margin callrisks, etc. Legal Risk: Lack of standard documentation and agreement as to the definitions ofcredit event leads to legal risks. Usage of master agreements though has simplifiedand homogenized the trading of credit derivatives. More efforts are being takenrecently to counter this risk with International Swaps and Derivatives Association(ISDA) taking active role in it. The most important legal issues still revolves aroundthe nature of credit event and the nature of obligations.Growth of Credit Derivatives Within no time credit derivatives have grown to a great extent to be a big part ofderivatives segment after interest rate contracts (82% Q4‟08) and foreign exchangecontracts (8.4% Q4‟08) as per notional amounts outstanding (Credit derivatives –7.9% Q4‟08. Much of the significance credit derivatives enjoy today is because of themarketability imparted by securitization. A securitized credit derivative, or syntheticsecuritization, is a device of embedding a credit derivative feature into a capitalmarket security so as to transfer the credit risk into the capital markets. The synthesisof credit derivatives with securitization methodology has complimented each other.This had allowed keeping the portfolio of assets on the books but transferring thecredit risk associated with it. The index products have also contributed to theincreasing popularity of credit derivatives. It provides a means to buy or sell exposureto a broad-based indices, or sub-indices diversifying the risks instead to buying orselling exposure to the credit risk of a single entity. The third important factor contributing to the growth of credit derivatives isstructured credit trading or tranching. Here the portfolio of assets is divided intovarious subclasses known as tranches (means slice in French) to fulfill the riskappetite of various investors. The tranches are divided into various levels like seniortranche, mezzanine tranche, subordinate tranche, and equity tranche with the risk ofdefault rising in a sequence for these tranches. Talking about the growth of creditderivatives from year-end 2003 to 2008,credit derivative contracts grew at a100% compounded annual growth rate.But due to the global turmoil the growthhas been curtailed from the end of2007. The composition of credit derivativesis shown in the figure. As can be seencredit default swaps dominates thecomposition of credit derivativesfollowed by total return swaps. Thecomposition of credit default swapssometimes makes people believe thatcredit derivatives are nothing but creditdefault swaps. Institute of Management Technology, Ghaziabad 4
  • 6. Credit DerivativesCredit Default SwapsOrigin of CDS By the mid-90s, JPMorgans books were loaded with billions of dollars in loans tocorporations and foreign governments, and by federal law it had to keep hugeamounts of capital in reserve in case any of them went bad. But what if JPMorgancould create a device that would protect it if those loans defaulted, and free up thatcapital? And the solution they come up with is nothing but the origin of “Credit DefaultSwap”. Credit Default Swap (CDS) is some sort of insurance policy where the third partyassumes the risk of debt going sour and in exchange will receive regular paymentsfrom the bank who issues debt, similar to insurance premiums. Although the idea wasfloating for a while JP Morgan was the first bank to make a bet on CDS. They openedup a Swap desk in mid-„90s and formally brought the idea of CDS into reality.Definition A credit default swap (CDS) is a credit derivative contract between twocounterparties. The buyer makes periodic payments to the seller, and in returnreceives a payoff if an underlying financial instrument defaults. There are three parties involved in a typical CDS contract – 1. Protection Buyer (Risk Hedger) 2. Protection Seller 3. Reference Entity Protection buyer is the one who pays a premium (CDS spread, generally a quarterlypremium) to the protection seller for taking credit risk to a reference entity and if thecredit event happens then protection seller will have to pay off. Typical credit eventsinclude – material default, bankruptcy, and debt restructuring. The size of thepayment is usually linked to the decline in the reference asset‟s market valuefollowing the credit event. The concept of CDS is explained pictorially in Figure 1. The interesting thing about CDS market is you don‟t need to own the underlyingreference entity to get into the contract. Such contract is known as naked CDS. Justlike any derivatives market CDS can be used for speculation, hedging and arbitragepurpose.Significance of Credit Default Swaps CDS creates Liquidity: The CDS adds depth to the secondary market ofunderlying credit instruments which may not be liquid for many reasons. Risk Management: Credit derivatives makes risk management more efficient andflexible by allocation of credit risk to most efficient manager of that risk. Risk Separation: Credit derivatives allows for separation of credit risk from otherrisks of the asset. Reliable funding source: Credit derivatives help exploit a funding advantage oravoiding a funding disadvantage. Since there is no up-front principal outlay requiredfor most Protection Sellers when assuming a Credit Swap position, these provide an Institute of Management Technology, Ghaziabad 5
  • 7. Credit Derivativesopportunity to take on credit exposure in off balance-sheet positions that do not needto be funded. On the other hand, institutions with low funding costs may capitalize onthis advantage by funding assets on the balance sheet and purchasing defaultprotection on those assets. The premium for buying default protection on such assetsmay be less than the net spread such a bank would earn over its funding costs. Figure 1CDS Premium Premium prices – also known as fees or credit default spreads – are quoted in basispoint per annum of the contract‟s notional value. In case of highly distressed credits inwhich CDS market remains open upfront premium payment is a common thing. TheCDS spread is inversely related to the credit worthiness of the underlying referenceentity.CDS Size & Price There are no predetermined limits on the size or maturity of CDS contracts, whichhave ranged in size from a few million to several billions of dollars. In general thecontracts are concentrated in the $10 million to $20 million range with maturities ofbetween one and 10 years, although 5 years maturities are the most common. Institute of Management Technology, Ghaziabad 6
  • 8. Credit Derivatives Inevitably, the maturity of a CDS will depend on the credit quality of the referenceentity, with longer-dated contracts of five years and more only written on the best-rated names. Although there are differences in the quotes given by banks on CDSprices due to some technical reasons rather than financial reasons, but the CDSpremium price more or less remains the same. Over and above a valuation of creditrisk, probability of default, actual loss incurred, and recovery rate, the various factorsin determination of CDS premium are – liquidity, regulatory capital requirements,market sentiments and perceived volatility, etc.Trigger Events The market participants view the following three to be the most important triggerevents:  Bankruptcy  Failure to Pay  Restructuring Bankruptcy, the clearest concept of all, is the reference entity‟s insolvency orinability to repay its debt. Failure-to-Pay occurs when the reference entity, after acertain grace period, fails to make payment of principal or interest. Restructuringrefers to a change in the terms of debt obligations that are adverse to the creditors.Growth of CDS Market Since the inception of the CDS market its growth has been astounding. The growthof CDS market over the period has been shown in the figure. As the market matured,CDSs came to be used less by banks seeking to hedge against default and more byinvestors wishing to bet for or against the likelihood that particular companies orportfolios would suffer financial difficulties as well as those seeking to profit fromperceived mispricing; the rapid growth of index compared with single name CDS after2003 reflected this change. The market sizefor Credit DefaultSwaps began to growrapidly from 2003;by the end of 2007,the CDS market hada notional value of$62 trillion (as seenin the above figure).But notional amountbegan to fall during2008 as a result ofdealer "portfoliocompression" efforts,and by the end of2008 notionalamount outstandinghad fallen 38 percentto $38.6 trillion. Institute of Management Technology, Ghaziabad 7
  • 9. Credit Derivatives It is important to note that since default is a relatively rare occurrence (historicallyaround 0.2% of investment grade companies would default in any one year) in mostCDS contracts the only payments are the spread payments from buyer to seller. Thus,although the above figures for outstanding notional amount sound very large, the netcash flows will generally only be a small fraction of this total. Currently CDS dominates the credit derivatives market with its unprecedentedgrowth. Although after the subprime crisis (which will be discussed later) the creditderivatives market, in the 4th quarter of 2008, reported credit derivatives notionalsdeclined 2%, or $252 billion, to $15.9 trillion, reflecting the industry‟s efforts toeliminate many offsetting trades (Reference: OCC‟s Quarterly Report). As shown in the chart above CDS represent the dominant product at 98% of allcredit derivatives notionals. As we can see from the other chart although majority ofthe CDSs composition is dominated by the investment grade CDSs sub-investmentgrade CDSs also forms a significant part of CDSs (34%) which is considered to be oneof prime cause for subprime crisis. Considering the global OTC market, the CDSaccounts for about 8%.Types of Credit Default Swaps The CDSs can be classified as Single-name CDSs or Multi-name CDSs.  Single-name CDS: These are credit derivatives where the reference entity is a single name.  Multi-name CDS: CDS contracts where the reference entity is more than one name as in portfolio or basket credit default swaps or credit default swap indices. A basket credit default swap is a CDS where the credit event is the default of some combination of the credits in a specified basket of credits. In the particular case of an nth-to-default basket it is the nth credit in the basket of reference credits whose default triggers payments. Another common form of multi-name CDS is that of the “tranched” credit defaultswap. Variations operate under specifically tailored loss limits – these may include a Institute of Management Technology, Ghaziabad 8
  • 10. Credit Derivatives“first loss” tranched CDS, a “mezzanine” tranched CDS, and a senior (also known as a“super-senior”) tranched CDS.Settlement methods for CDS The settlement for CDSs can be done in either of two ways: Physical Settlement orCash Settlement.  Physical Settlement: The seller of the protection will buy back the distressed reference entity at par. Clearly given that the credit event will have reduced the secondary market value of the underlying reference entity, this will result in protection seller (CDS seller) incurring a loss. This was the most common means for the settlement in CDSs and will generally take place no later than 30 days after the credit event. Till 2006 ISDA2 allowed settlement only in the form of physical settlement. But due to increased amount of naked CDSs in the credit market ISDA has now allowed the choice between cash and physical settlement.  Cash Settlement: The seller of the protection will pay the buyer the difference between the notional of the default swap and a final value for the same notional of the reference obligation. Cash settlement is less prevalent because obtaining precise quotes can be difficult when the reference credit is distressed. After the Auction process being started for the settlement of CDSs as per ISDA, this problem has been resolved. The example for the Physical and Cash settlement shown below will explain theprocess.Uses of Credit Default Swaps As mentioned already CDSs can be used for speculation, hedging or arbitrage. Outof which we will be consideringhedging and speculation indetail.CDS for Hedging When JP Morgan inventedthe credit instrument namedCDS they meant it to be forhedging their credit risk.Although market has changed alot since then but still the useof CDSs for hedging purposeremains to be a primaryreason. Credit default swaps areoften used to manage thecredit risk (i.e. the risk ofdefault) which arises fromholding debt. Typically, the Institute of Management Technology, Ghaziabad 9
  • 11. Credit Derivativesholder of, for example, a corporate bond may hedge their exposure by entering into aCDS contract as the buyer of protection. If the bond goes into default, the proceedsfrom the CDS contract will cancel out the losses on the underlying bond. For example, if you own a bond of Apple worth $10 million maturing after 5 yearsand you are worried about its future then you can create a CDS contract with aninsurance company like AIG which will charge a premium of say 200bps annually forinsuring your bond. In this way you are hedging the risk of losing $10 million in caseApple goes bankrupt. Here you will be paying $200000 to AIG for insuring your bond.If Apple goes bankrupt you will receive the par value of bond from AIG and even ifdoes not, you will lose premium value at the most which is worth transferring the riskto AIG.Counterparty Risks When entering into a CDS, both the buyer and seller of credit protection take oncounterparty risk. Examples of counter party risks:  The buyer takes the risk that the seller will default. If reference entity and seller default simultaneously ("double default"), the buyer loses its protection against default by the reference entity. If seller defaults but reference entity does not, the buyer might need to replace the defaulted CDS at a higher cost.  The seller takes the risk that the buyer will default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying offsetting protection from another party - that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, that may be at a lower price than the original CDS and may therefore involve a loss to the seller. As is true with other forms of over-the-counter derivative, CDS might involveliquidity risk. If one or both parties to a CDS contract must post collateral (which iscommon), there can be margin calls requiring the posting of additional collateral. Therequired collateral is agreed on by the parties when the CDS is first issued. Thismargin amount may vary over the life of the CDS contract, if the market price of theCDS contracts changes, or the credit rating of one of the party‟s changes.CDSs for Speculation Credit default swaps allow investors to speculate on changes in CDS spreads ofsingle names or of market indexes such as the North American CDX index3 or theEuropean iTraxx index4. An investor might speculate on an entitys credit quality,since generally CDS spreads will increase as credit-worthiness declines and decline ascredit-worthiness increases. The investor might therefore buy CDS protection on acompany in order to speculate that the company is about to default. Alternatively, theinvestor might sell protection if they think that the companys creditworthiness mightimprove. As there is no need to own an underlying entity to enter into a CDS contractit can be viewed as a betting or gambling tool. For example if you feel that Microsoft is not performing well and may go bankruptin near future then you might enter into a CDS contract with AIG for a notional valueof $10 million for 5 years even if you don‟t own a single share of Microsoft. This kindof CDS is known as Naked CDS.Institute of Management Technology, Ghaziabad 10
  • 12. Credit DerivativesChanging Nature of CDS Market towards Speculation CDS was originally meant for hedging but as market matured the market hasmoved more towards using it for speculation purpose. Speculation entered the CDSmarket in three forms: 1) using structured investment vehicles such as MBS, ABS,CDO and SIV securities as the underlying asset, 2) creating CDS between partieswithout any connection to the underlying asset, and 3) development of a secondarymarket for CDS. Much has been written about the structured investment vehicle market and the lackof understanding of what was included in the various products. Sellers of protection inthe CDS market more than likely did not have sufficient understating of the underlyingasset to determine an appropriate risk profile (plus there was no history of theseproducts to assist in determining a risk profile). As it has become clear, the structuredinvestment vehicle market was a speculative market which was not really understoodwhich led to speculative CDS related to these products. A larger problem is the pure speculation in the CDS market. Many hedge funds andinvestment companies started to write CDS contracts without owning the underlyingsecurity, but were just a "bet" on whether a "credit event" would occur. These CDScontracts created a way to "short" sell the bond market, or to make money on thedecline in the value of bonds. Many hedge funds and other investment companiesoften place "bets" on the price movement of commodities, interest rates, and manyother items, and now had a vehicle to "short" the credit markets. [Actually CDS can be viewed as short in bond and buying a put option. Because inthe case of default protection buyer will have to give the underlying reference entity(bond) to the protection seller (in case of physical settlement) so shorting the bond.While protection seller will have to pay the par amount to protection buyer in case ofdefault hence can be viewed to be a put option. The payout to credit protection buyercan be described as – Asset value at the time of swap – Asset market value; Payout to investor = if default 0; if no default So above expression can be viewed as binary put option based on two states of theworld: default and no default.] A still larger problem was the development of a secondary market for both legs ofthe CDS product, particularly the seller of protection. The problem may be that a"weak link" would occur in the chain of sales even if the CDS terms are the same. The"weak link" is often a speculative buyer that offers to sell protection, but, in fact, isjust looking to quickly turn the product to another investor. This problem becomesparticularly acute when the CDS is based on structured investment vehicles and firmslooking for a quick profit. An insurance company may unknowingly be pulled into one of these speculativeaspects of the CDS market. The insurance company would be viewed as "the deeppocket" and may be asked (or sued) to recover losses by the buyer of protection.Institute of Management Technology, Ghaziabad 11
  • 13. Credit DerivativesCDS is not insurance In many terms CDS is like an insurance policy where there is a regular premium tobe paid, there is a reference entity and in case of default a pay-off will be paid. ButCDS differs in many aspects from insurance like –  The seller need not be a regulated entity  The seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements (because CDS dealers are generally banks).  Insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets.  In the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract.  The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. By contrast, to purchase insurance the insured is generally expected to have an insurable interest such as owning a debt.CDS Pricing The main aim of CDS pricing is to calculate the amount of premium to be paid byprotection buyer to the protection seller. For calculating the CDS premium we need toknow the Recovery Rate and Probability of Default. Simple explanation of calculatingCDS premium (spread) for a 1-year CDS contract (with yearly premium) is shownbelow. Let S = CDS premium (spread), p = probability of default, R = recovery rate. The protection buyer expects to pay S. And his expected payoff is (1-R) p. When the two parties enter a CDS contract, S is set so that the value of swaptransaction is zero. That is, S = (1-R) pCredit Derivatives Market in India Banks are major players in the credit market and are, therefore, exposed to creditrisk. Credit market is considered to be an inefficient market with market players likebanks and financial institutions mostly have loans and little of bonds in their portfolioswhile mutual funds, insurance companies, pension funds and hedge funds have mostlybonds in their portfolios, with little access to loans, depriving them of high returns ofloans portfolios. The market in the past did not provide the necessary credit riskprotection to banks and financial institutions. Neither did it provide any mechanism tothe mutual funds, insurance companies, pension funds and hedge funds to have anaccess to loan market to diversify their risks and earn better return. Credit derivativeswere, therefore, developed to provide a solution to the inefficiencies in the creditmarket. Internationally, banks are able to protect themselves from the credit riskthrough the mechanism of credit derivatives. However, credit derivative has not yetbeen used by banks and financial institutions in India in a formal way.Institute of Management Technology, Ghaziabad 12
  • 14. Credit DerivativesBenefits from Credit Derivatives Banks and Financial Institutions currently require a mechanism that would allowthem to provide long term financing without taking the credit risk if they so desire.Currently banks and financial institutions need to hold their portfolios on booksdepriving them of diversifying the portfolio as well as making them forgo some of theopportunities. Also non-banking institutions loses on some of the opportunities ofholding high yielding portfolios like loans. Credit derivatives would help resolve these issues. Banks and the financialinstitutions derive four main benefits from credit derivatives, namely:  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. Apart from above mentioned benefits credit derivatives also provides better liquiditythan the existing mechanisms of managing the risks like insurance, guarantee,securitization, etc. It also allows financial intermediaries to gain access to high gainportfolios.Participants in the Indian Market In order to ensure that the credit market functions efficiently, it is important tomaximize the number of participants in the market to encompass banks, financialinstitutions, NBFCs (all regulated by RBI), mutual funds, insurance companies andcorporates.Minimum Conditions As per Report of the Working Group on Introduction of Credit Derivatives in Indiaby Department of Banking Operations and Development the bank should fulfillminimum conditions relating to risk management processes and that the creditderivative should be direct, explicit, irrevocable and unconditional. These conditionsare explained below.  Direct: The credit protection must represent a direct claim on the protection provider.  Explicit: The credit protection must be linked to specific exposures, so that the extent of the cover is clearly defined and incontrovertible.  Irrevocable: Other than a protection purchaser‟s non-payment of money due in respect of the credit protection contract, there must be no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover.  Unconditional: There should be no clause in the protection contract that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original obligor fails to make the payment(s) due.Institute of Management Technology, Ghaziabad 13
  • 15. Credit DerivativesDraft CDS Guidelines Reserve Bank of India (RBI) has come out with draft guidelines on Credit DefaultSwap (CDS) per notification dated May 2007. The details of which are as follows:Participants allowedProtection Buyers:  Commercial banks and Primary dealers  A protection buyer shall have an underlying credit risk exposure in the form of permissible underlying asset / obligationProtection Sellers:  Commercial banks and Primary dealers  RBI will consider allowing insurance companies and mutual funds as protection buyer or protection seller as and when their respective regulators permit them to transact in credit default swaps.Product Requirements: Structure: A CDS may be used –  By the eligible protection buyers, for buying protection on specified loans and advances, or investments where the protection buyer has a credit risk exposure.  By the eligible protection sellers, for selling protection on specified loans and advances, or investments on which the protection buyer has a credit risk exposure. Settlement Methods:  Physical Settlement  Cash Settlement  Fixed Amount Settlement (binary CDS) Documentation:  1992 or 2002 ISDA Master Agreement compliance.  2003 ISDA Credit Derivatives Definitions and subsequent supplements to definitions compliance.  Documenting the establishment of the legal enforceability of the contracts in all relevant jurisdictions before undertaking CDS transactions. Credit Events:  Bankruptcy  Obligation Acceleration  Obligation Default  Failure to pay  Repudiation/ Moratorium  RestructuringInstitute of Management Technology, Ghaziabad 14
  • 16. Credit Derivatives Minimum Requirements:  A CDS contract must represent a direct claim on the protection seller and must be explicitly referenced to specific exposures of the protection buyer, so that the extent of the cover is clearly defined and indisputable. It must be irrevocable.  The CDS contract shall not have any clause that could prevent the protection seller from making the credit event payment in a timely manner after occurrence of the credit event and completion of necessary formalities in terms of the contract.  The protection seller shall have no recourse to the protection buyer for losses.  The credit events specified in the CDS contract shall contain as wide a range of triggers as possible with a view to adequately cover the credit risk in the underlying / reference asset and, at a minimum, cover – o Failure to pay o Bankruptcy, insolvency or inability of the obligor to pay its debts o Restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event  CDS contracts must have a clearly specified period for obtaining post-credit- event valuations of the reference asset, typically no more than 30 days  The credit protection must be legally enforceable in all relevant jurisdictions  The underlying asset/ obligation shall have equal seniority with, or greater seniority than, the reference asset/ obligation.  The protection buyer must have the right/ability to transfer the reference/ deliverable asset/ obligation to the protection seller, if required for settlement (in case of physical settlement).  The credit risk transfer should not contravene any terms and conditions relating to the reference / deliverable / underlying asset / obligation and where necessary all consents should have been obtained.  The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay. The grace period in the credit derivative contract must not be longer than the grace period agreed upon under the loan agreement.  The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection seller of the occurrence of a credit event.  Where there is an asset mismatch between the underlying asset/ obligation and the reference asset/ obligation then: o The reference and underlying assets/ obligations must be issued by the same obligor (i.e. the same legal entity) o The reference asset must rank pari passu or more junior than the underlying asset/ obligation; and o There are legally effective cross-reference clauses between the reference asset and the underlying asset.Institute of Management Technology, Ghaziabad 15
  • 17. Credit DerivativesRisk Management:  Banks should consider carefully all related risks and rewards before entering the credit derivatives market. They should not enter into such transaction unless their management has the ability to understand and manage properly the credit and other risks associated with these instruments. They should establish sound risk management policy and procedures integrated into their overall risk management.  Banks which are protection buyers should periodically assess the ability of the protection sellers to make the credit event payment as and when they may fall due. The results of such assessments should be used to review the counterparty limits.  Banks should be aware of the potential legal risk arising from an unenforceable contract, e.g. due to inadequate documentation, lack of authority for a counterparty to enter into the contract, etc.  The credit derivatives activity to be undertaken by bank should be under the adequate oversight of its Board of Directors and senior management (via a copy of a resolution passed by their Board of Directors or via adequate MIS).Procedures: The bank should have adequate procedures for:  Measuring, monitoring, reviewing, reporting and managing the associated risks.  Full analysis of all credit risks to which the banks will be exposed, the minimization and management of such risks.  Ensuring that the credit risk of a reference asset is captured in the bank‟s normal credit approval and monitoring regime.  Management of market risk associated with credit derivatives held by banks in their trading books by measuring portfolio exposures at least daily using robust market accepted methodology.  Management of the potential legal risk arising from unenforceable contracts and uncertain payment procedures.  Determination of an appropriate liquidity reserve to be held against uncertainty in valuation. Now after understanding the need for credit derivatives and the draft guidelinesprovided by RBI we will now understand the possible settlement procedures to beadopted for CDS contracts.CDS & its settlement in India The Reserve Bank of India (RBI) has taken the first step towards introducing creditdefault swaps (CDS) to India‟s financial markets by sending out feelers to a number ofbanks with a view to gauging the acceptability of CDS contracts. The questionnairesent by RBI to the banks enquires about bankers‟ expectations from the derivativeinstrument. Although CDSs for the Indian companies like ICICI Bank, Tata Motors, SBIetc. are already traded in US and some Asian market it is yet to be traded in Indianmarket. And RBI is looking at CDS for debt issued in the domestic market. The moveby RBI to launch CDS in India is considered significant considering its cautious natureand the role CDS played in subprime crisis. The move is welcomed by some of thebanks. “There is surely a need for such a product (CDS)” said Ashish Vaidya, head ofInstitute of Management Technology, Ghaziabad 16
  • 18. Credit Derivativesinterest rate trading at HDFC Bank. “Indian regulators have the benefit of learningfrom the difficult experience (in derivatives) in the West and can build in a robustsystem that effectively curtails the concentration of risks in a few hands”. RBI expectsto develop the corporate bond market through the introduction of CDS contracts.CDS 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 The Clearing Corporation of India (CCIL) was set up with the prime objective toimprove efficiency in the transaction settlement process, insulate the financial systemfrom shocks emanating from operations related issues, and to undertake other relatedactivities that would help to broaden and deepen the Money, Gilts and Forex marketsin India. The role of CCIL is unique as it provides settlement of three differentproducts under one umbrella. It has been instrumental in setting up and runningelectronic trading platforms like NDS-OM, NDS-Call and NDS-Auction system for thecentral bank that had helped the Indian market to evolve and grow immensely. It hadalso immensely bolstered CCILs image in terms of ability to provide transparent,efficient, robust and cost effective end to end solutions to market participants invarious markets. The introduction of ClearCorp14 Repo Order Matching System(CROMS), an anonymous Repo trading platform, has also changed the trading patternin Repo market i.e. shifting of interest from specific security to basket of securities.The success of its money market product CBLO has helped the market participants aswell as RBI to find a solution to unusual dependence on uncollateralized call market.The total settlement volume during 2009-10 in government securities, forex marketand CBLO stood at Rs.14934 billion, Rs.25424 billion, and Rs.20433 billionrespectively. The CCIL already has the necessary infrastructure for the settlement of OTCproducts like interest rate swaps and forward rate agreement. CCIL already has atrade reporting platform for IRS which provides non-guaranteed settlement for thereported trades. Now CCIL is moving towards the guaranteed settlement of IRS whichwill involve trade matching, initial and MTM margining, exposure check, novation,multilateral netting, default handling etc. On this backdrop one can say CCIL is wellequipped with all its experience to act as central counterparty for the settlement ofCDS contracts. But before the introduction of CDS contracts in India, there are some issues thatneed to be handled for the effective CDS market. Those are –  Although RBI has allowed insurance companies and mutual funds as protection buyer or protection seller, the permission of respective regulators needs to be addressed quickly before making CDS market open. Otherwise it may obstruct the stipulated expeditious growth of the CDS in India and will also defeat theInstitute of Management Technology, Ghaziabad 17
  • 19. Credit Derivatives purpose of CDS, i.e., to maximize the number of participants in the market and transmit the credit risk from the banking system to other risk seeking financial entities.  As per the draft guidelines provided by RBI restructuring is considered as a credit event which has created many legal disputes in the global CDS market. Considering the complexities associated with the restructuring, restructuring as a credit event has been removed from North American CDS contracts. So more clear information on restructuring as credit event is required.  As CDS contract in India is only allowed if the protection buyer bears the loss making it similar to insurance. Considering this close proximity of CDS contract with that of insurance contract, CDS contract should be made to be out of the purview of regulations of insurance contract making it incontrovertible. Although CDS has helped in perforation of subprime crisis which has creatednegative vibes about CDS but CDS as in instrument is very effective means of hedgingyour risk. And in India it is expected to provide the needed push to the corporatebond market. So it won‟t be long for the CDS market to pick up in India.First Credit Default Swap in India The first credit-default-swap trades offering protection on Indian corporate bondswere completed on Dec 7, 2011, according to separate statements from Indias IDBIBank and ICICI Bank. IDBI said it underwrote one CDS transaction and ICICI said it was responsible foranother. The combined trade sizes totalled $1.9 million, according to the ClearingCorporation of India, Ltd., and comprised a pair of trades each worth 50 millionrupees. The protection was sold on bonds issued by Indias Rural Electrification Corp. Ltd., alender to the power sector, and Indian Railway Finance Corp. Ltd. The buyers of protection paid 90 basis points. One basis point translates to $1,000a year on a derivatives contract used to protect $10 million of debt against default forfive years.Institute of Management Technology, Ghaziabad 18
  • 20. Credit Derivatives References -Investopedia.com -Introduction to Credit Derivative Article by Vinod Kothari -hereisthecity.com -Futures and Options by J.C. Hull -RBI warms up to credit default swaps”, The Economic Times, dated 30 June 2009 -OCC‟s Quarterly Report -ISDA -Call Reports -CCILInstitute of Management Technology, Ghaziabad 19

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