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  • 1. A PROJECT REPORT ON Credit Default Swaps- An Emerging Financial Product Its Effect On Indian Market IN PARTIAL FULFILLMENT OFREQUIREMENT OF POST GRADUATE DIPLOMA IN MANAGEMENT PROGRAMME NIILM- Centre for Management Studies Submitted To:- Submitted By:-Sukumar Dutta Varun NarangFaculty (Finance) Ashish Ghosh Northern Integrated Institute Of Learning Management Centre for Management Studies Greater Noida, New Delhi Emergence of Credit Default Swaps in India
  • 2. CREDIT DEFAULT SWAPSEFFECT ON INDIAN MARKET Emergence of Credit Default Swaps in India
  • 3. Emergence of Credit Default Swaps in India
  • 4. ContentsEXECUTIVE SUMMARY ............................................................................................................ 5EVOLUTION OF CREDIT DEFAULT SWAPS .......................................................................... 8 The Rise of the Credit Default Swap Market.............................................................................. 9UNDERSTANDING OF CDS AS A BUILDING BLOCK OF CREDIT DERIVATIVES........ 19UNDERSTANDING RISK IN CREDIT DEFAULT SWAP ...................................................... 28LIQUIDITY AND CREDIT DEFAULT SWAP SPREADS ....................................................... 43CREDIT DEFAULT SWAP INDEX OPTIONS ......................................................................... 50 Credit Default Swap Indexes .................................................................................................... 51 OTC Credit Default Swap Index Derivatives ........................................................................... 53 Exchange Traded Options ......................................................................................................... 53 Exchange-Traded CDX Options ............................................................................................... 54 Market and Customers .......................................................................................................... 54 Pricing and Liquidity Issues of CDS .................................................................................... 56 Pricing of Exchange-Traded CDX Options .......................................................................... 57 Structure of Exchange-Traded CDX Options ....................................................................... 58 Practical Considerations........................................................................................................ 59CREDIT DEFAULT SWAPS, CLEARING HOUSE AND EXCHANGES ............................... 61CREDIT DEFAULT SWAPS AND COUNTERPARTY RISK .................................................. 69EFFECT OF CREDIT DEFAULT SWAPS IN INDIAN MARKET ........................................... 89CASES ON CREDIT DEFAULT SWAPS .................................................................................. 95Falling Giant: A Case Study Of AIG ............................................................................................ 96CONCLUSION ........................................................................................................................... 114BIBLIOGRAPHY ....................................................................................................................... 117 Emergence of Credit Default Swaps in India
  • 5. EXECUTIVE SUMMARYThe credit default swap (CDS) market is a large and fast-growing market that allows investors totrade credit risk. Multiple derivatives on CDS currently trade over the counter including CDO-like tranches and options. The rise of standardized, liquid, and high-volume CDS indexes hascreated the possibility of exchange-traded CDS index options. Exchange-traded options wouldincrease liquidity in the CDS option market and allow retail and smaller investors to trade creditrisk much more easily than with current products. The primary users of the exchange-tradedoptions will be speculators as existing products, such as individual CDS or the CDS indexes, arecost-effective hedges for most players. CDS index options could be an attractive new product for the CBOE but there are severalmajor issues to overcome before exchange-traded CDS index options are viable. The mostsignificant barrier to offering exchange-traded CDS index options is the risk that the CDS tradinginfrastructure will fail during a credit crisis. The CBOE can mitigate, but not eliminate, this riskby carefully drafting contract provisions. The easy hedgability of CDS index options should beattractive to market-makers but current OTC CDS option dealers might be unwilling to support acompetitive exchange-traded product. There are also practical barriers to the product such asSEC and index licensing issues.The proposed contract is a European option on the current on-the-run series of the NorthAmerican Investment Grade CDX. The size of the contract is one hundred times the currentspread of the underlying CDX index and the contract is settled based on the CDX spread. Inorder to lessen competition with the OTC market, the contract is sized to appeal to smallerplayers and the retail market, a new customer base for CDS optionsCredit risk has been attracting a great deal of attention recently. Risk-management practitionersand regulators have all been working intensively on the development of methodologies andsystems to quantify credit risks. At the same time, the market for credit derivatives has grownrapidly in recent years, and it is expected to continue growing. Credit Default Swaps (CDS) havebecome the most liquid credit derivative instruments. In terms of outstanding notional, theyrepresent around 85% of the credit derivatives market, which has a total outstanding notional inexcess of USD 4000 billions. Not only are they the most important credit derivative instrument, Emergence of Credit Default Swaps in India
  • 6. but they are also the building block for many of the other more exotic structures traded in thecredit derivatives market.Briefly, CDS are instruments by which an investor, referred to as protection buyer, buysprotection against the losses derived from the default of a given firm. The party which acts asinsurer in a CDS contract, referred to as protection seller, receives, from the protection buyer, aperiodic fee as payment for the insurance. In return for such payments, the protection seller isresponsible to, in case of default of the firm, reimburse the protection buyer the losses derived. With India having grown at an average of 8.6% in the past 4 years, there has been anexcessive demand for capital from all sorts of businesses to further fuel their growth. Banks seekto address this need for capital and in turn assume risk. But for India to continue to grow at over9% it‘s an imperative that we have healthy financial institutions which are able to manage theirrisks well. Credit derivatives which emerged globally nearly a decade ago and created a rage aseffective tools for credit risk management are set to make their debut in India to help banks bettermanage their credit risks. This paper seeks to address the immense relevance of credit derivatives, particularly CDS,in the Indian context. The introduction shall provide an overview of the significant features of therecent guidelines on the introduction of CDS. The paper highlights the positive/negativeimplications of the introduction of CDS and the issues that may emerge as the market gains scale.The paper shall also endeavor to identify issues which demand urgent attention of the regulatorsto ensure the healthy growth of credit derivatives in India. The RBI recently released the ―Draft Guidelines on Credit Default Swaps‖, as a small firststep towards creating an onshore credit derivatives market. The guidelines aim to introduce CDSin a calibrated manner in India and are reflective of a conservative approach adopted by the RBI.The conservatism possibly stems from the inexperience of the Indian markets with such products,but could in-part also be attributed to derivatives being viewed as ―financial weapons of massdestruction‖. The role credit derivatives had to play in the recent Sub-prime crisis does to anextent validate the adopted approach. The guidelines regulate credit derivative transactions byIndian resident commercial banks & primary dealers. Currently only plain vanilla credit defaultswaps (CDS) have been permitted. The guidelines limit CDS trades to transactions referenced to Emergence of Credit Default Swaps in India
  • 7. single rated, resident entities only, with both the protection buyers (PB) and protection sellers(PS) being resident. The PB must be in a position to identify a specific credit exposure which it ishedging, and this exposure may have to be referenced in the CDS. The reference obligation and, ifdifferent, the deliverable obligation must be rated and denominated in Indian Rupees. Relatedparty transactions have been disallowed and the CDS must be denominated and settled in Indianrupees.The rather disheartening feature of the guidelines is that banks are allowed to use CDS but onlyfor hedging purposes. Globally, credit derivatives are being used not only for hedging purposesbut also for creating exposures to certain assets. This policy measure also deprives the creditderivatives market of the much needed liquidity extended by the presence ofspeculators/arbitragers. The guidelines stipulate that the CDS contract shall not have a materialitythreshold and this shall help further reduce the credit exposure of banks. The guidelines requirethat the reference obligation be identical with the underlying exposure and this may be ratherimpossible to achieve practically. Emergence of Credit Default Swaps in India
  • 8. CHAPTER – 1EVOLUTION OF CREDIT DEFAULT SWAPS Emergence of Credit Default Swaps in India
  • 9. EVOLUTION OF CREDIT DEFAULT SWAPSThe Rise of the Credit Default Swap MarketA credit default swap (CDS) is a contract between two parties where a protection buyer pays apremium to the protection seller in exchange for a payment if a credit event occurs to a referenceentity. CDS are customizable, over-the-counter products and can be written to trigger in theevent of bankruptcy, default, failure to pay, restructuring, or any other credit event of thereference entity. Despite the potential to customize CDS, most of the contracts are standardizedto increase the tradability of the contract. The contracts are often written to trigger in the case ofthe specified credit event for any of the debt of the entity, even subordinated debt.1 In addition,CDS are typically 5 year contracts, although 3, 7, and 10 year contracts are also traded. CDS canbe physically settled or cash settled. If a physically-settled CDS is triggered, the protection sellerpays the face value of the debt (or another pre-specified amount) to the protection buyer inexchange for the debt itself, which would be worth less than face value given the recent creditevent. Triggering a cash-settled CDS would require the protection seller to make a payment tothe protection buyer of the difference between the original value of the debt (typically the facevalue) and the current value of the debt based on a specified valuation method. Unlike hedgingwith less risky bonds which requires a cash outlay upfront, CDS do not subject the buyer tointerest rate risk or funding risk. CDS allow hedgers or speculators to take an unfunded positionsolely on credit risk.The CDS market is an important market that has grown dramatically over a short period of time.The market originally started as an inter-bank market to exchange credit risk without selling theunderlying loans but now involves financial institutions from insurance companies to hedgefunds. The British Bankers Association (BBA) and the International Swaps and DerivativesAssociation (ISDA) estimate that the market has grown from $180 billion in notional amount in1997 to $5 trillion by 2004 and the Economist estimates that the market is currently $17 trillionin notional amount.2 This rapid growth was spurred by the ISDA creating a set of standardizeddocumentation. This standardized industry standards and benchmarks which greatly lowered thetransactions costs to trading CDS. Emergence of Credit Default Swaps in India
  • 10. The credit default swap (CDS) market is one of the purest and most responsive indicators ofcorporate financial health. Since the release of ISDA‘s ―Master Agreement,‖ CDS transactionshave become simpler and CDS markets have become available to a whole new universe ofinvestors. As Goldman Sachs expressed in a bulletin published in May 2001: ―…use of defaultswaps will increasingly become a necessary component of any successful portfolio managementstrategy.‖EMERGENCE OF CREDIT DEFAULT SWAPSCredit Default Swaps (CDS) were originally created in the mid-1990s as a means to transfercredit exposure for commercial loans and to free up regulatory capital in commercial banks. Byentering into CDS, a commercial bank shifted the risk of default to a third-party and this shiftedrisk did not count against their regulatory capital requirements.In the late 1990s, CDS were starting to be sold for corporate bonds and municipal bonds. By2000, the CDS market was approximately $900 billion and was viewed as, and working in, areliable manner, including, for example, CDS payments related to some of the Enron andWorldcom bonds. There were a limited number of parties to the early CDS transactions, so theparties were well-acquainted with each other and understood the terms of the CDS product. Inmost cases, the buyer of the protection also held the underlying credit asset (loan or bond).However, in the early 2000s, the CDS market changed in three substantive manners:  Numerous new parties became involved in the CDS market through the development of a secondary market for both the sellers of protection and the buyers of protection. Therefore, it became difficult to determine the financial strength of the sellers of protection  CDS were starting to be issued for Structured Investment Vehicles, for example, ABS, MBS, CDO and SIVs. These investments no longer had a known entity to follow to determine the strength of a particular loan or bond (as in the case of commercial loans, corporate bonds or municipal bonds.); and Emergence of Credit Default Swaps in India
  • 11.  Speculation became rampant in the market such that sellers and buyer of CDS were no longer owners of the underlying asset (bond or loan), but were just "betting" on the possibility of a credit event of a specific asset.The result was that by the end of 2007, the CDS market had a notional value of $45 trillion, butthe corporate bond, municipal bond, and structured investment vehicles market totaled less than$25 trillion. Therefore, a minimum of $20 trillion were speculative "bets" on the possibility of acredit event of a specific credit asset not owned by either party to the CDS contract.Another result was that the original two parties that entered into the CDS contract may very wellnot be the current holders of the rights of the protection buyer and protection seller. Some CDScontracts are believed to have been passed through 10-12 different parties. The financial strengthof all the multiple parties may not be known. Therefore, it has become very difficult todetermine, or "unwind," the parties of the CDS in the event of a "credit event."Finally, a "credit event" that triggers the initial CDS payment may not trigger a downstreampayment. For example, AON entered into a CDS as the seller of protection. AON resold itsinterest to another company. The bond at issue defaulted and AON paid the $10 million due tothe default. AON then sought to recover the $10 million from the downstream buyer, but wasunsuccessful in litigation - so AON was stuck with the $10 million loss even though they hadsold the protection to another party. The legal problem was that the downstream contract toresell the protection did not exactly match the terms of the original CDS contract.Sub-Prime Mortgages and other Asset-Backed ProblemsThe problems in the subprime mortgage area which started in the summer of 2007 exposed theproblems in the CDS market. As the subprime mortgage and their related CDOs started to havevaluation problems, and ultimate defaults, the sellers of protection in the CDS market started torealize that the CDS tied to collateralized subprime mortgages and other CDO-type securitieswere going to require substantial payments.For example, Swiss Reinsurance entered into two CDS as the seller of protection for two CDOstotaling $1.5 billion that contained collateralized subprime mortgages and other collateralized Emergence of Credit Default Swaps in India
  • 12. assets. The CDOs "credit event" was triggered due to reduced values of the CDOs underlyingmortgages. In October 2007, Swiss Re wrote down the value of the CDS a total of $1.1 billionbased on the reduced values of the two CDOs (and the subsequent payment required to coverthose losses). In April 2008, Swiss Re took another $240 million write-down for continuedreduced value in the two CDOs.Insurance Company RisksInsurance company may be exposed as both buyers of protection and sellers of protection in theCDS market. Many insurance companies have entered into CDS as buyers of protection as ahedge against the potential decline in their vast bond holdings, including holdings of ABS, MBSand CDO. The risk to the insurance companies on the buyer side is that the counterparty (sellerof protection) will not have sufficient assets to pay if a "credit event" occurs. This is commonlyreferred to as counterparty liquidity risk. If the counterparty does not have the ability to pay, theinsurance company realizes a loss on the bond holding and loses its premiums that it paid for theprotection.The bigger problem most likely occurs when the insurance company is the seller of protection asSwiss Re was in the earlier example. Insurance companies often enter into the CDS as a seller ofprotection since the CDS pays a stream of premiums that is a consistent source of investmentincome for the company. Premiums are generally 3%-5% of the value of the underlying asset andare paid on a quarterly basis. However, the risk of payment unknowingly increased when theCDS were related to securities such as CDOs, ABS and MBS which are fraught with structuralproblems, but were offered as secure investments. In this scenario, the insurance company mayhave to pay large amounts to the buyer of protection, which dwarfs the stream of premiumsreceived.The value of a CDS is based on computer modeling of cash flows including the stream ofpremium payments less projected pay-outs due to anticipated events of default in the underlyingdebt or, at least, the risk of payment for such events of default. As the stream of premiums isoften set by the contract terms, the volatility of values in CDS is primarily due to changes in therisk of projected pay-outs due to events of default. For example, AIG wrote-down the value of Emergence of Credit Default Swaps in India
  • 13. its CDS portfolio by $20 billion during the past two quarters. AIG sold credit default swaps toholders of CDOs guaranteeing payments in the event of default in the underlying debt, whichwere pools of subprime mortgages. In simple terms, as the risk of higher subprime mortgagedefaults increased in the CDOs, the credit default swap values decreased due to the risk ofanticipated higher pay-outs by the CDS seller (in this example, AIG) to cover the increasedevents of default.Speculation Enters the MarketSpeculation entered the CDS market in three forms: 1) using structured investment vehicles suchas 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 secondary market forCDS.Much has been written about the structured investment vehicle market and the lack ofunderstanding of what was included in the various products. Sellers of protection in the CDSmarket more than likely did not have sufficient understating of the underlying asset to determinean appropriate risk profile (plus there was no history of these products to assist in determining arisk profile). As it has become clear, the structured investment vehicle market was a speculativemarket which was not really understood, which led to speculative CDS related to these products.A larger problem is the pure speculation in the CDS market. Many hedge funds and investmentcompanies started to write CDS contracts without owning the underlying security, but were just a"bet" on whether a "credit event" would occur. These CDS contracts created a way to "short"sell the bond market, or to make money on the decline in the value of bonds. Many hedge fundsand other investment companies often place "bets" on the price movement of commodities,interest rates, and many other items, and now had a vehicle to "short" the credit markets.A still larger problem was the development of a secondary market for both legs of the CDSproduct, particularly the seller of protection. The problem may be like the AON example above.The problem may be that a "weak link" would occur in the chain of sales even if the CDS termsare the same. The "weak link" is often a speculative buyer that offers to sell protection, but, infact, is just looking to quickly turn the product to another investor. This problem becomes Emergence of Credit Default Swaps in India
  • 14. particularly acute when the CDS is based on structured investment vehicles and firms looking fora quick profit.An insurance company may unknowingly be pulled into one of these speculative aspects of theCDS market. The insurance company would be viewed as "the deep pocket" and may be asked(or sued) to recover losses by the buyer of protection.Litigation IssuesCDS are sold as individual contracts and appear not to be subject to securities laws (further legalresearch in this area is warranted). There is no regulatory body that governs the buying andselling of CDS. The International Swaps and Derivatives Association (ISDA) does providerecommended CDS documentation guidelines, but the ISDA is not a regulatory body that issuesregulations which are enforceable.Causes of action in the CDS market are most likely tied to the underlying CDS contract(s) inplace, in both the original market and the secondary markets, related to the underlying asset thatsuffered a "credit event." Further, CDS as an industry is in its infancy, especially, regarding thestructured investment vehicles and the speculative products and, as such, the litigation history islimited to date and is still being developed.WHAT ARE CREDIT DEFAULT SWAPS?Credit Default Swaps (CDS) are a private contract between two parties in which the buyer ofprotection agrees to pay premiums to a seller of protection over a set period of time, the mostcommon period being five years. In return, the seller of protection agrees to pay the buyer anamount of loss created by a "credit event" related to an underlying credit asset (loan or bond) -the most common events are bankruptcy, restructuring or default. Each individual contract laysout the specific terms of their agreement including identifying the underlying asset (loan orbond) and what constitutes a credit event. Emergence of Credit Default Swaps in India
  • 15. Even though CDS appear to be similar to insurance, it is not a form of insurance. Rather it is aninvestment (more akin to an option) that "bets" on whether a "credit event" will or will notoccur. CDS do not have the same form of underwriting and actuarial analysis as a typicalinsurance product rather is based on an analysis of the financial strength of the entity issuing theunderlying credit asset (loan or bond). There are no regulatory capital requirements for the sellerof protection (such as exists with insurance companies and banks).CDS are not regulated and are "sold" through "brokered" arrangements. Initially, commercialbanks were the "broker" that put together the two sides of the CDS contract. However,investment banks became very involved in "brokering" the CDS contracts for corporate bonds,municipal bonds and, later, structured investment vehicles. CDSs are a product within the creditderivative asset class, constituting a type of OTC derivative. They are bilateral contracts in whicha protection buyer agrees to pay a periodic fee (called a ―premium‖) and/or an upfront paymentin exchange for a payment by the protection seller in the case of a credit event (such as abankruptcy) affecting a reference entity or a portfolio of reference entities such as a CDS index .The market price of the premium is therefore an indication of the perceived risk related to thereference entity. There are three main types of CDS. Emergence of Credit Default Swaps in India
  • 16. First, the ―single-name CDS‖ offers protection for a single corporate or sovereign referenceentity.Second, CDS indices are contracts which consist of a pool of single-name CDSs, whereby eachentity has an equal share of the notional amount within the index. The standardization andtransparency of indices has contributed strongly to the growth of index contracts.8 In June 2009this segment accounted for almost half of all CDS contracts in terms of notional outstandingamounts, compared with virtually nil in 2004.Liquidity for benchmark indices is enhanced by including only the most liquid single-nameCDSs. Market participants have come to view the CDS indices as a key source of priceinformation. Official prices for these indices are collected by Markit and published on a dailybasis. CDS indices do not cease to exist after credit events, instead continuing to trade withreduced notional amounts.In addition, a market has also developed for CDS index tranches, whereby CDS contracts relateto specific tranches (also known as ―synthetic CDOs‖) within an established CDS index. Eachtranche covers a certain segment of the losses distributed for the underlying CDS index as aresult of credit events.Third, basket CDSs are similar to indices, as they relate to portfolios of reference entities, whichcan comprise anything from 3 to 100 names. However, basket CDSs may be more tailored thanindex contracts and are more opaque in terms of their volumes and pricing. Basket CDSs, forexample, include specific sub-categories such as first-to-default CDSs (where investors areexposed to the first default to occur within the basket of reference entities). In addition,derivative instruments such as CDS options (called ―CDS swaptions‖) are now also being traded. Emergence of Credit Default Swaps in India
  • 17. Holders of these instruments are entitled – but not obliged – to enter into forward-start CDScontracts to buy or sell protection. This type of instrument may benefit from increased investorinterest in the environment of increased transparency that may result from stronger migration ofCDSs to CCPs. It is important to distinguish between standard single-name CDSs or indexcontracts and the more complex bespoke CDS contracts, as the latter can be very different(having, among other things, different degrees of liquidity and embedded leverage) and arefrequently used for different purposes. Although disentangling the various uses of CDSs issomewhat artificial, one approach has been to distinguish between CDSs for hedging and tradingpurposes. In the first category, CDSs can be used to hedge the credit risk of on-balance sheetassets (e.g. corporate bonds or asset-backed securities) by acquiring CDS protection on them.Such protection provides capital relief and insures the acquirer of protection against credit losses(assuming the terms of the CDS contract provide for perfect hedging). Commercial banks andother lenders are natural buyers ofCDS protection for such purposes, while highly rated dealers, insurance companies, financialguarantors and credit derivative product companies were the typical protection sellers prior to thefinancial crisis. They can also be used to hedge counterparty exposure. As part of their dailytrading activities, dealers take on unsecured exposures to other financial institutions. Creditdefault swaps provide a mechanism for the hedging of such counterparty exposures and arehighly sought after by market participants during periods of considerable market distress. Theyprovide protection by producing a gain if credit spreads on their counterparties widen.Derivatives can also be used as trading tools, for speculating or arbitrage purposes. Speculatorsand arbitragists add liquidity to the market by ―connecting‖ markets and eliminating pricinginefficiencies between them. First, they allow a counterpart to acquire long exposure to creditassets in an unfunded (synthetic) form when selling CDS protection.The leverage embedded in credit default swaps (like that in other derivative instruments) offer ahigher return on equity than acquiring the credit assets outright. In the presence of wideningcredit spreads, CDSs can offer equity-like returns and are therefore attractive to hedge funds, oreven the more traditional bond funds. In addition, credit default swaps, by their very nature asOTC products, can be used to create bespoke exposures by enabling counterparties to chooseeither single-name or multi-name reference entities and by customizing their pay-off triggers andamounts. Emergence of Credit Default Swaps in India
  • 18. These highly customized products are usually illiquid and consequently require a substantialamount of sophisticated modeling to estimate potential pay-off scenarios.Second, CDSs also allow the acquisition of uncovered short exposure to credit assets whenbuying CDS protection. The acquirer of CDS protection effectively shorts the underlyingreference asset(s). Shorting cash bonds is considerably more difficult because it requires theshort-seller to borrow the assets, which is usually difficult to accomplish with fixed incomesecurities, particularly if the short-seller seeks to go short on a portfolio of assets. Hedge funds,or dealers with long CDS exposures, which need to be hedged, are active acquirers of CDSprotection.To conclude, CDSs are not only risk management tools for banks but also contribute to thecompleteness of the market, by providing market participants with a possibility to take a view onthe default risk of a reference entity, on a company or a sovereign borrower. Thereby and asshown during the crisis, derivatives allow for pricing of risk that might otherwise be difficult dueto lack of liquidity in the underlying assets. Emergence of Credit Default Swaps in India
  • 20. UNDERSTANDING CREDIT DEFAULT SWAPS AS A BUILDING BLOCK FORCREDIT DERIVATIONWhat are credit derivatives? Derivatives growth in the latter part of the 1990s continues along at least threedimensions. Firstly, new products are emerging as the traditional building blocks – forwards andoptions – have spawned second and third generation derivatives that span complex hybrid,contingent, and path-dependent risks. Secondly, new applications are expanding derivatives usebeyond the specific management of price and event risk to the strategic management ofportfolio risk, balance sheet growth, shareholder value, and overall business performance .Finally , derivatives are being extended beyond mainstream interest rate, currency , commodity ,and equity markets to new under lying risks including catastrophe, pollution, electricity ,inflation, and credit . Credit derivatives fit neatly into this three-dimensional scheme . Until recently, creditremained one of the major components of business risk for which no tailored risk-managementproducts existed. Credit risk management for the loan portfolio manager mean t a strategy ofportfolio diversification backed by line limits, with an occasional sale of positions in thesecondary market . Derivatives users relied on purchasing insurance, letters of credit, orguarantees, or negotiating collateralized mark- to-market credit enhancement provisions inMaster Agreements . Corporates either carried open exposures to key customers‘ accountsreceivable or purchased insurance, where available, from factors. Ye t these strategies areinefficient, largely because they do not separate the management of credit risk from the assetwith which that risk is associated. For example, consider a corporate bond, which represents a bundle of risks, includingperhaps duration, convexity, callability, and credit risk (constituting both the risk of default andthe risk of volatility in credit spreads). If the only way to adjust credit risk is to buy or sell thatbond, and consequently affect positioning across the entire bundle of risks, there is a clearinefficiency. Fixed income derivatives introduced the ability to manage duration, convexity, andcallability independently of bond positions; credit derivatives complete the process by allowingthe independent management of default or credit spread risk. Emergence of Credit Default Swaps in India
  • 21. Formally, credit derivatives are bilateral financial contracts that isolate specific aspects ofcredit risk from an underlying instrument and transfer that risk between two parties. In so doing,credit derivatives separate the ownership and management of credit risk from other qualitativeand quantitative aspects of ownership of financial assets. Thus, credit derivatives share one ofthe key features of historically successful derivatives products, which is the potential to achieveefficiency gains through a process of market completion. Efficiency gains arising fromdisaggregating risk are best illustrated by imagining an auction process in which an auctioneersells a number of risks, each to the highest bidder, as compared to selling a ―job lot‖ of the samerisks to the highest bidder for the entire package. In most cases, the separate auctions will yield ahigher aggregate sale price than the job lot. By separating specific aspects of credit risk fromother risks, credit derivatives allow even the most illiquid credit exposures to be transferred fromportfolios that have but don‘ t want the risk to those that want but don‘ t have that risk, evenwhen the underlying asset itself could not have been transferred in the same way.What is the significance of credit derivatives? Even today, we cannot yet argue that credit risk is, on the whole, ―actively‖ managed.Indeed, even in the largest banks, credit risk management is often little more than a process ofsetting and adhering to notional exposure limits and pursuing limited opportunities for portfoliodiversification. In recent years, stiff competition among lenders, a tendency by some banks totreat lending as a loss-leading cost of relationship development, and a benign credit cycle havecombined to subject bank loan credit spreads to relentless downward pressure, both on anabsolute basis and relative to other asset classes. At the same time, secondary market illiquidity,relationship constraints, and the luxury of cost rather than mark-to-market accounting have madeactive portfolio management either impossible or unattractive. Consequently, the vast majorityof bank loans reside where they are originated until maturity. In 1996, primary loan syndicationorigination in the U.S. alone exceeded $900 billion, while secondary loan market volumes wereless than $45 billion. However, five years hence, commentators will look back to the birth of the creditderivative market as a watershed development for bank credit risk management practice. Simplyput, credit derivatives are fundamentally changing the way banks price, manage, transact,originate, distribute, and account for credit risk. Yet, in substance, the definition of a credit Emergence of Credit Default Swaps in India
  • 22. derivative given above captures many credit instruments that have been used routinely for years,including guarantees, letters of credit, and loan participations. So why attach such significanceto this new group of products? Essentially, it is the precision with which credit derivatives canisolate and transfer certain aspects of credit risk, rather than their economic substance, thatdistinguishes them from more traditional credit instruments. There are several distinctarguments, not all of which are unique to credit derivatives, but which combine to make a strongcase for increasing use of credit derivatives by banks and by all institutions that routinely carrycredit risk as part of their day-to-day business. First, the Reference Entity, whose credit risk is being transferred, need neither be a partyto nor aware of a credit derivative transaction. This confidentiality enables banks and corporatetreasurers to manage their credit risks discreetly without interfering with important customerrelationships. This contrasts with both a loan assignment through the secondary loan market,which requires borrower notification, and a silent participation, which requires the participatingbank to assume as much credit risk to the selling bank as to the borrower itself. The absence of the Reference Entity at the negotiating table also means that the terms(tenor, seniority, compensation structure) of the credit derivative transaction can be customizedto meet the needs of the buyer and seller of risk, rather than the particular liquidity or term needsof a borrower. Moreover, because credit derivatives isolate credit risk from relationship andother aspects of asset ownership, they introduce discipline to pricing decisions. Creditderivatives provide an objective market pricing benchmark representing the true opportunity costof a transaction. Increasingly, as liquidity and pricing technology improve, credit derivatives aredefining credit spread forward curves and implied volatilities in a way that less liquid creditproducts never could. The availability and discipline of visible market pricing enablesinstitutions to make pricing and relationship decisions more objectively. Second, credit derivatives are the first mechanism via which short sales of creditinstruments can be executed with any reasonable liquidity and without the risk of a shortsqueeze. It is more or less impossible to short-sell a bank loan, but the economics of a shortposition can be achieved synthetically by purchasing credit protection using a credit derivative.This allows the user to reverse the ―skewed‖ profile of credit risk (whereby one earns a smallpremium for the risk of a large loss) and instead pay a small premium for the possibility of alarge gain upon credit deterioration. Consequently, portfolio managers can short specific credits Emergence of Credit Default Swaps in India
  • 23. or a broad index of credits, either as a hedge of existing exposures or simply to profit from anegative credit view. Similarly, the possibility of short sales opens up a wealth of arbitrageopportunities. Global credit markets today display discrepancies in the pricing of the samecredit risk across different asset classes, maturities, rating cohorts, time zones, currencies, and soon. These discrepancies persist because arbitrageurs have traditionally been unable to purchasecheap obligations against shorting expensive ones to extract arbitrage profits. As creditderivative liquidity improves, banks, borrowers, and other credit players will exploit suchopportunities, just as the evolution of interest rate derivatives first prompted cross-marketinterest rate arbitrage activity in the 1980s. The natural consequence of this is, of course, thatcredit pricing discrepancies will gradually disappear as credit markets become more efficient. Third, credit derivatives, except when embedded in structured notes, are off-balance-sheet instruments. As such, they offer considerable flexibility in terms of leverage. In fact, theuser can define the required degree of leverage, if any, in a credit investment. The appeal of off-as opposed to on-balance-sheet exposure will differ by institution: The more costly the balancesheet, the greater the appeal of an off-balance-sheet alternative. To illustrate, bank loans havenot traditionally appealed as an asset class to hedge funds and other nonbank institutionalinvestors for at least two reasons: first, because of the administrative burden of assigning andservicing loans; and second, because of the absence of a repo market. Without the ability tofinance investments in bank loans on a secured basis via some form of repo market, the return oncapital offered by bank loans has been unattractive to institutions that do not enjoy access tounsecured financing. However, by taking exposure to bank loans using a credit derivative suchas a Total Return Swap (described more fully below), a hedge fund can both syntheticallyfinance the position (receiving under the swap the net proceeds of the loan after financing) andavoid the administrative costs of direct ownership of the asset, which are borne by the swapcounterparty. The degree of leverage achieved using a Total Return Swap will depend on theamount of up-front collateralization, if any, required by the total return payer from its swapcounterparty. Credit derivatives are thus opening new lines of distribution for the credit risk ofbank loans and many other instruments into the institutional capital markets. Emergence of Credit Default Swaps in India
  • 24. Basic credit derivative structures and applicationsThe most highly structured credit derivativestransactions can be assembled by combining three mainbuilding blocks:1 Credit (Default) Swaps2 Credit Options3 Total Return Swaps The most common type of credit derivative isthe credit default swap. A credit default swap or option is simply an exchange of a fee inexchange for a payment if a ―credit default event‖ occurs. Credit default swaps differ fromTotal Rate of Return Swaps in that the Investor does not take price risk of the Reference Asset,only the risk of default. The Investor receives a fee from the Seller of the default risk. TheInvestor makes no payment unless a Credit Default Event occurs.The traditional or ―Plain Vanilla‖ credit default swap is a payment by one party in exchange for acredit default protection payment if a credit default event on a reference asset occurs. Theamount of the payment is the difference between the original price of the reference asset and therecovery value of the reference asset. The following schematic shows how the cash flow of thiscredit derivative transaction work:If the fee is paid up front, which may be the case for very short dated structures, the agreementis likely to be called a credit default option. If the fee is paid over time, the agreement is morelikely to be called a swap. Unless two counterparties are actually swapping and exchanging the Emergence of Credit Default Swaps in India
  • 25. credit default risk of two different credits, I prefer to call the former structure a credit defaultoption. Cash flows paid over time are nothing more than an amortization of an option premium.Because the documentation references ISDA master agreements, however, swap terminology hascrept into the market. Since the credit derivatives business at many commercial and investmentbanks is often run by former interest rate swap staff, the tendency to use swap terminologypersists. Therefore, I will most often refer to these transactions as credit default ―swaps‖. The credit default premium is usually paid over time. For some very short datedstructures, the credit default premium may be paid upfront. In fact, professionals new to thismarket often ask if the premium should be paid upfront, instead of over time. After all, if thecredit defaults, the default protection Seller will get no additional premiums. The credit default option or swap is a contingent option, and not to be confused with anAmerican option. A Termination Payment is only made if a Credit Event occurs. If the creditevent does not occur, the default protection Seller has no obligation. The premium can bethought of as the credit spread an Investor demands to take the default risk of a given ReferenceAsset. If the Investor bought an asset swap, the Investor would earn a spread to his funding costrepresenting the compensation, the premium, the Investor would need to take the credit defaultrisk of the Reference Asset in the asset swap. For an American option, the premium is paid upfront (or over time, but with the provisothat the total premium is owed, even if exercise occurs before the expiration date). TheAmerican option can be exercised any time that it is in the money. The holder of the option doesnot have to exercise, however, and can wait and hope the option will go further in the money. Ifthe market reverses direction, the American option can again become out-of-the money, and theholder who failed to exercise the option when it was in the money cannot exercise. With a creditdefault option, once the trigger event has occurred, the holder must exercise and the option staysexercisable. Default Protection can be purchased on a loan, a bond, sovereign risk due to cross bordercommercial transactions, or even on credit exposure due to a derivative contract such asCounterparty credit exposure in a cross currency swap transaction. Credit protection can belinked to an individual credit or to a basket of credits. At first glance, a credit default swap or option looks structurally simpler than a totalreturn swap. We already know that a total return swap is simply a form of financing. In this Emergence of Credit Default Swaps in India
  • 26. chapter we will explore the complex, various, and interesting features of the credit default swapand the credit default option market. Complex? Various? Wait a minute. Didn‘t I mention thata total return swap already has a credit default swap imbedded in its structure? After all, if myCounterparty is taking the default risk of a bond or a loan, I have reduced my credit exposure tothat reference asset. We understand everything there is to know about credit default swapsalready. Don‘t we? That is the question most practitioners ask themselves the first time they enter into acredit default contract. The first key difference is that although the price or premium of a creditdefault swap or option may increase, it is never actually in-the-money until a credit default eventas defined by the confirm language has occurred. That seems like a knock-in option or a knock-in swap, which is a type of barrier option. Knock-in options have been around since the 1960‘s.When a market price reaches a pre-determined strike price, the barrier, the knock-in optioncomes into existence. But this ―knock-in‖ is not linked to traditional market factors, but rather toeither credit default or a credit ―event‖. If the option ―knocks in‖ then, and only then, is theoption in the money. The termination payment is usually not binary or pre-defined, although wewill explore exceptions in this chapter. The termination payment is linked to a recovery value orrecovery rate for the reference credit or reference credits involved. The terminology is further complicated by the US market‘s use of the word swap to referto an exchange of one bond for another (usually accompanied by a cash payment to make up forany discrepancy in relative values), and the UK market‘s use of the term ―switch‖ for the sametransaction. US market practitioners are often mystified when they first hear of ―asset swapswitches‖, an exchange of one asset swap package risk for another asset swap package risk. Wewill discuss this product later in this chapter. As we will see later, a variety of structures have evolved in this market. The riskcharacteristics of these structures are different from the structures we have discussed so far andmerit close scrutiny. One structure known by such names as: Digital, binary, all-or-nothing, andthe zero-one structure has a substantial amount of risk. The Investor loses the entire notionalamount – not merely coupon and some principal loss- if there is a default event. Other structures such as the ‗par value minus recovery value‘ structure can leave aposition of premium bonds partially unhedged or can overhedge a position of bonds trading Emergence of Credit Default Swaps in India
  • 27. below par. Exposure management officers evaluating the suitability and appropriateness of suchdeals must be fully aware of the full exposures implied in these transactions. The credit swap becomes even more interesting when one realizes that the term ―defaultevent‖ does not even apply to many credit agreements. The event, which triggers a terminationpayment under the terms of the credit default swap confirmation, is negotiable. The event maybe defined as a spread widening, an event in a foreign country that may cause its sovereign debtto decline in price, or just about any event upon which the two parties can agree and define aprice. Even the termination payment is negotiable. It may be pre-set at a fixed amount, or basedon the recovery value of a reference asset, to mention only two structures. Some credit ―default‖ options, those linked to spread widening, for instance, soundsuspiciously like put options which are struck out-of-the-money.Importance of the Default Protection Seller If an Investor is purchasing credit default protection, what kind of credit defaultprotection Seller is most desirable? If prices were the same, a default protection Seller with atriple A credit rating and a 0% correlation with the asset the Investor is trying to hedge would bethe most desirable. But as we saw in the section on Total Rate of Return Swaps, a defaultprotection Seller with these characteristics will probably sell very expensive protection.Therefore, it is beneficial to relax the criteria and find another provider. The Investor should beaware that there are unsuitable providers, however. There are unsuitable applications, too. One must as the right questions before trying toapply a solution. Credit derivatives are sometimes seen as the panacea, the answer to any financeproblem, which cannot be solved by conventional market strategies.The whole point of using credit derivatives is to diversify credit risk. Asset swap spreads are independent of the credit quality of the Investor. A market assetis swapped to a LIBOR based floating coupon, for instance. The market is indifferent to thecredit quality of the Investor, who pays cash up front for the asset swap package. Unlike an assetswap, the premium paid to the ―Investor‖, the credit default protection Seller, is sensitive to thecredit quality of the Investor. The premium is further sensitive to the correlation between the―Investor‖ and the reference asset on which one is buying the credit default protection. Emergence of Credit Default Swaps in India
  • 28. Depending on the structure, the credit default swap contract may require an un-collateralizedpayment by the ―Investor‖ if there is a credit default event.. CHAPTER – 3 UNDERSTANDING RISK IN CREDIT DEFAULT SWAP Emergence of Credit Default Swaps in India
  • 29. UNDERSTANDING RISK IN CREDIT DEFAULT SWAPSCredit derivatives offer unique opportunities and risks to investors. They allow investors to haveexposure to a firm without actually buying a security or loan issued by that firm. Because theexposure is synthetic, the transaction can be tailored to meet investors‘ needs with respect tocurrency, cash flow, and tenor, among other things. However, if the transaction is not structuredcarefully, it may pass along unintended risks to investors. Significantly, it may expose investorsto higher frequency and severity of losses than if they held an equivalent cash position. Moodyshas rated numerous structured transactions — mostly synthetic collateralizeddebt obligations (CDOs) and credit-linked notes (CLNs) — whose key feature is a cash-settledcredit default swap. Under the swap, losses to investors are determined synthetically, based on―credit events‖ occurring in a reference portfolio.Investors‘ risk, thus, is driven largely by the definition of ―credit events‖ in the swap. Thedefinitions published by the International Swaps and Derivatives Association (ISDA) are, inmany respects, broader than the common understanding of ―default,‖ and thus impose risk of lossfrom events that are not defaults. For example,Moodys — and much of the market — considers certain types of ―restructuring‖ events to be―defaults.‖ However, the current ISDA definition of ―restructuring‖ is broader than Moodysdefinition of ―default,‖ and includes events that would not be captured by a Moodys rating.Likewise, the ISDA definitions for other credit events — e.g., bankruptcy, obligationacceleration, and obligation default — are broader than Moodys definition of ―default.‖ For theMoodys rating of a reference portfolio to capture the risks to investors, the ―credit events―should be narrowed such that they are consistent with ―defaults‖ — the events captured by aMoodys rating.Many of the risks in these transactions are driven by moral hazard — the inherent conflicinterestthat exists because the sponsoring financial institution (which is buying protection frominvestors) determines when a loss event has occurred as well as how much loss is imposed oninvestors. The sponsors incentive, of course, is to construe ―credit events‖ as expansively aspossible and to calculate losses as generously as possible. Moodys considers these riskscarefully when issuing its ratings. In addition to tightening the credit event and loss calculation Emergence of Credit Default Swaps in India
  • 30. provisions, these risks can be addressed by increasing transparency and providing mechanismsfor objectively verifying loss determinations and calculations.Setting aside moral hazard, risks also arise based on the inherent difficulty in valuing a defaultedcredit to determine the extent of loss to investors. Calculated losses may vary based on liquidity,market conditions, and the identity of the parties supplying bids. In analyzing a credit defaultswap, Moodys looks carefully at the methods and procedures for calculating loss given default,to ensure that all calculations are meaningful, realistic, and fair.The ISDA Credit Derivatives definitions, as currently drafted, do not effectively unbundle―credit risk‖ from other risks. If not structured carefully, a credit default swap using the ISDAdefinitions can pass along risks other than ―credit risk.‖ For example, the swap may pass alongthe risk of loss following credit deterioration short of default. Such a risk is not necessarilycaptured by aMoodys rating of the reference portfolio, and, with some exceptions (e.g., when the loss event isa rating downgrade) is not readily capable of being measured.The capital markets have an enormous capacity for absorbing credit risk, and this capacity hasonly been partially tapped by the credit derivatives market. In Moody‘s opinion, for capitalmarkets investors to participate fully in the credit derivatives market, the risks inherent in creditdefault swaps must be more precisely defined, more transparently managed, and more readilyquantifiable.This special report will describe the typical cash-settled credit default swap underlying asynthetic CDO or CLN,1 compare Moody‘s definition of default with the credit event definitionscurrently used in the ISDA documentation, and discuss how different structural features andparameters of a credit default swap can affect risks to investors and impact Moody‘s analysis andratings.A swap can be structured to provide for either physical settlement or cash settlement followinga credit event. In a physically settled swap, the buyer of protection delivers to the seller anobligation of the reference entity that has experienced a credit event. The seller pays par for thatasset, thus reimbursing the buyer for any default-related loss that it would otherwise suffer.In a cash-settled swap, the buyer of protection is not required to deliver the defaulted credit, butvalues the credit — for example, by marking it to market or by using a final workout value — Emergence of Credit Default Swaps in India
  • 31. and is reimbursed for the loss (measured by the difference between par and the value followingdefault).THE TYPICAL STRUCTUREThrough synthetic CDOs or CLNs, financial institutions utilize credit default swaps to ―buy‖credit protection — usually from the capital markets in the form of issued securities, but alsodirectly from counterparties in the form of over-the-counter swap transactions. The structureallows financial institutions to remove credit exposure from their balance sheets while retainingownership of the assets, and thus (1) manage risk more efficiently, and (2) obtain economicand/or regulatory capital relief.In the typical structure, the sponsoring financial institution (the entity seeking protection againstcredit losses) sets up a special purpose vehicle (SPV) to serve as counterparty to the creditdefault swap (making the SPV the provider of protection). The SPV is funded with the proceedsof notes issued to investors; it will use those proceeds to make credit event payments to thefinancial institution, and to return any remaining principal to investors at the deal‘s maturity. Theproceeds of the securities are typically invested in highly rated securities in such a way that theratings of the notes can be ―de-linked‖ from the rating of the sponsoring institution. Emergence of Credit Default Swaps in India
  • 32. Under the swap, the SPV is the ―seller‖ of protection, and the financial institution is the―buyer.‖The swap references a credit exposure, or portfolio of credit exposures, for whichprotection is being provided. The arrangement is similar to an insurance policy, in which thefinancial institution is buying insurance against losses due to default in its portfolio. The creditexposures can be assets physically owned by the sponsor (e.g., loans, bonds, other securities),exposures to counterparties (e.g., by way of currency or interest rate swaps), or syntheticexposures (e.g., if the sponsor has sold protection on particular assets by way of credit defaultswaps). Typically, in a synthetic CDO, the financial institution retains the firstloss piece, and themezzanine tranches are securitized and sold to investors. There is often a ―super senior‖ piecethat is either retained by the sponsor or passed off to a counterparty by way of a swap. There area number of key variations on the structure that can have a significant impact on the analysis ofthe transaction: The reference pool can be static — remaining the same throughout the life of the transaction — or it can be dynamic, permitting removal and substitution of the individual reference credits pursuant to portfolio guidelines. The swap can provide for ongoing cash settlement — as defaults happen and losses are incurred — or it can provide for cash settlement only at the maturity of the deal. The procedure and timing for determining severity of loss on a defaulted credit reference can vary — from a bidding procedure that takes place shortly after a default, to reliance on a final ―work-out― value established after the formal workout process has been completed. Emergence of Credit Default Swaps in India
  • 33. The swap can reference specific credits, or it can reference the general, unsecured debt of a reference entity. If the swap references the general, unsecured debt of an entity, credit events under the swap can be triggered by defaults only on ―bonds or loans‖, on a broader class of ―borrowed money,― or on an even broader class of ―payment obligations.― Perhaps most significantly, the definition of ―credit event‖ can be tailored to meet the needs of the various parties to the transaction. While each of these variations is important, the most heavily negotiated component is most often the designation and characteristics of the ―credit events‖ that will trigger a cash settlement under the swap.MOODY’S DEFINITION OF DEFAULT AND LOSSIn assigning ratings and compiling its historical default statistics, Moody‘s considers thefollowing events to be defaults:• Any missed or delayed disbursement of interest and/or principal;• Bankruptcy or receivership; and• Distressed exchange where(i) the borrower offers debt holders a new security or package of securities that amount to adiminished financial obligation (such as preferred or common stock, or debt with a lower couponor par amount), or (ii) the exchange has the apparent purpose of helping the borrower avoiddefault. Severity of loss is defined as the difference between par and the recovery rate —measured as a percentage of par — following default. Moody‘s uses the market value ofdefaulted instruments, approximately one month after default, as an estimate of recovery rate.5These are the events that constitute ―defaults― in Moody‘s historical studies, and these are theevents that can be predicted by a Moody‘s rating.ISDA CREDIT EVENTSThe 1999 ISDA Credit Derivatives Definitions6 currently list six ―credit events‖ that can beincorporated into credit swaps:• Bankruptcy;• Failure to pay;• Restructuring,• Repudiation/moratorium;• Obligation default; and Emergence of Credit Default Swaps in India
  • 34. • Obligation acceleration.While these are the so-called ―standard‖ credit events, their inclusion and scope are alwaysheavily negotiated in the context of Moody‘s-rated synthetic CDOs and CLNs. The choice andcharacterization of these events is crucial, because they determine the probability of a lossoccurring under the swap, as well as the extent of any such loss. Some of the ISDA credit eventsare consistent with Moody‘s definition of ―default,‖ and some are not.BankruptcyThe definition of ―Bankruptcy‖ in the ISDA Credit Derivatives Definitions was copied wholesalefrom the ISDA Master Agreement. Thus, while most of the definition is consistent with a―default,― there are some components that are not.The last clause of the definition, a catchall provision, is problematic because it makes a ―creditevent‖ any action by the reference entity “in furtherance of, or indicating its consent to,approval of, or acquiescence in” one of the listed bankruptcy events. This clause exposesinvestors to potentially greater risks; because it includes events that are vague, difficult toidentify, and do not clearly indicate default.7Another potentially troublesome item in the ISDA bankruptcy definition is ―insolvency.‖ TheISDA definition does not specify what is intended by ―insolvency.‖However, there are different definitions — for example, by reference to balance sheet or incomestatement tests — and, depending on the definition used, the timing of an insolvency ―creditevent― could vary. Under a very broad definition, it is conceivable that an ―insolvency‖ couldoccur without being followed by an actual bankruptcy or failure to pay. Thus, a broadinterpretation could lead to a ―credit event― being called under the swap when no ―default― hasactually occurred.Failure to PayThe ISDA ―failure to pay‖ definition is consistent with Moody‘s definition of ―default.‖ The keyissue under this definition is materiality — i.e., the missed payment should be in an amount thatis material, such that it would be captured by a Moody‘s rating.To ensure that a credit event is not triggered by the failure to pay a trivial amount, a minimumamount — referred to as the ―Payment Amount‖ in the ISDA definitions — should be specifiedunder the swap. While there is a standard minimum amount, that amount may not be appropriatein all transactions, and it should be considered carefully for each swap. In some cases, the choice Emergence of Credit Default Swaps in India
  • 35. of a Payment Amount will depend on whether the swap is referencing (1) a specific obligation,(2) bonds or loans, (3) borrowed money, or (4) the more general ―payment obligations‖ — all ofwhich are options under the current ISDA documentation. A Moody‘s rating will capture the riskof a ―failure to pay‖ on the obligations rated by Moody‘s — usually bonds and loans. However,it may not capture the risk of non-payment on all of an entity‘s payment obligations — e.g.,disputed trade obligations, certain fees, etc. An entity may choose not to make a payment on oneof its ―payment obligations‖ for reasons other than credit problems. To ensure that a Moody‘srating will capture the risk of payment default, the category of obligations being referencedshould be carefully considered. In some circumstances, a higher minimum payment amount maybe appropriate.RestructuringMoody‘s considers certain types of ―restructuring― events — known as ―distressed exchanges‖— to be defaults, and captures those events in its ratings. Thus, Moody‘s does not believe that―restructuring,‖ as a concept, needs to be excluded from the credit derivatives definitions. Inmany respects, however, the current ISDA definition of ―restructuring‖ is broader than Moody‘sdefinition of ―distressed exchange,― and includes events that are not captured by a Moody‘srating.9 Thus, for a Moody‘s rating of the reference portfolio to capture the risk to investors, thedefinition of ―restructuring― should be tightened to make it consistent with ―distressedexchange.‖Under the current ISDA ―restructuring‖ definition, five events can qualify as a ―restructuring.‖Each event must meet the following requirements to qualify as a ―credit event:‖ the restructuring(1) must not have been provided for in the original terms of the obligation, and (2) must be theresult of a deterioration in the obligor‘s creditworthiness or financial condition. While theserequirements are helpful in restricting the events that could constitute ―credit events,‖ they arenot sufficient to prevent overbroad applications of the definition.The first three events under the definition — restructuring of an obligation that leads to (1) areduction in interest payment amounts, (2) a reduction in principal repayment amounts, or (3) apostponement or deferral of interest or principal payments — can constitute ―distressedexchange‖ defaults under Moody‘s definition. Any one of these events, by itself, would arguablylead to a ―diminished financial obligation.‖ However, if combined with other changes to theobligation, they may not. For example, an obligation that has been restructured to defer principal Emergence of Credit Default Swaps in India
  • 36. payments may not be considered a ―diminished financial obligation‖ — and thus not a―distressed exchange‖ — if the lender has been compensated for the deferral.Thus, any ―restructuring‖ definition should look at the totality of the circumstances — e.g.,whether the lenders/investors have been compensated for the reduction or deferral — todetermine whether the restructured obligation is truly a ―diminished financial obligation.‖The fourth ISDA ―restructuring‖ event — a restructuring that leads to a change in an obligation‘spriority, causing it to be subordinated — can be overbroad. The subordination of a debtobligation to equity or preferred stock would clearly be a ―default.‖ (It would probably lead to afailure to pay as well — thus, rendering this ―restructuring‖ event unnecessary). However, arestructuring that merely lowers an obligation from a senior to a subordinated position in thecapital structure (but not to equity) could also trigger a ―credit event‖ under the current ISDAdefinition.Repudiation/MoratoriumRepudiation/moratorium was included in the ISDA definitions mainly to address actions bysovereign lenders, and thus, is not included in many synthetic CDO‘s, where the exposure isprimarily to corporate credit. When applied to corporate credits, repudiation/moratorium isgenerally consistent with Moody‘s views of default — although it is unclear how it would bedifferent from ―failure to pay.‖ However, there is concern with respect to the provision thatincludes as a credit event when a borrower ―challenges the validity of . . . one or moreObligations.‖ This provision could be construed overbroadly to include situations where there isa legal dispute over a borrowing — in which, for example, the borrower unsuccessfullychallenges some terms of the borrowing — that does not ultimately lead to a failure to payinterest or principal. Moody‘s would not necessarily consider such an event to be a default.In addition, if this event is to be included, the ―Default Amount,‖ or minimum amount that canbe subject to a repudiation in order to trigger a credit event, should be material, so that therepudiation of a trivial amount will not trigger a credit event.Obligation DefaultISDA defines ―Obligation Default‖ as a non-payment default — i.e., a default other than a failureto pay — that renders an obligation capable of being accelerated. Moody‘s has not been asked to Emergence of Credit Default Swaps in India
  • 37. rate a transaction that includes this credit event, and the market has moved away from includingit. This is because the event is much broader than Moody‘s — and most of the market‘s —definition of ―default.‖Most bonds and loans contain representations, warranties, financial covenants, and non-financialcovenants, the violation of which can give lenders the right to accelerate. While such violationscan indicate credit deterioration (e.g., failure to maintain a minimum financial ratio, taking onadditional debt, etc.) Many such violations can be technical (e.g., failure to send a report).Of course, Moody‘s ratings do not capture the probability of a technical violation occurring.Moreover, even a covenant violation that represents serious credit deterioration would not becaptured if the obligation is still current on interest and principal, and has not carried out a―distressed exchange‖ or become bankrupt. Moody‘s simply does not have data concerning suchevents that would allow it to assign a rating to them.Because inclusion of this event forces counterparties to mark-to-market an obligation before apayment default occurs, it will cause investors (i.e., ―sellers‖ of credit protection) to take lossesthat they would not incur if they actually bought and held the obligation.For example, even though an obligation has suffered credit deterioration giving rise to a financialcovenant violation, there is still a good chance that the obligation will pay both interest andprincipal in full. However, at the time of the violation, market bids will likely come in below par,because of concerns about the credit, or because of market sentiment, interest rate movements, orother systematic factors. Thus, while an investor that actually holds the obligation to maturitywill get out whole, the investor ―selling‖ protection will not.Obligation Acceleration―Obligation acceleration‖ is similar to ―obligation default.‖ However, to trigger a credit event,the non-payment default — i.e., default other than a failure to pay — must lead to a referenceloan, bond, or other obligation actually being accelerated. Like obligation default, anacceleration, by itself, would not be captured by a Moody‘s rating. A failure to pay, bankruptcy,or distressed exchange following acceleration would be captured, but the acceleration itselfwould not.Acceleration is simply a lender‘s exercise of its contractual right, under certain circumstances, todeclare a debt immediately due and payable.14 As with ―obligation default,― the events giving Emergence of Credit Default Swaps in India
  • 38. rise to a right to accelerate under ―obligation acceleration‖ — defaults other than a failure to pay— are not considered by Moody‘s to be ―defaults‖ and would not be captured by aMoody‘s rating. Consequently, a lender‘s decision to exercise its acceleration right followingsuch events is not captured either. There are three possible outcomes following an acceleration:(1) the borrower repays less than it owes (or becomes bankrupt), (2) the debt is renegotiated, or(3) the borrower repays everything that it owes. The first outcome is already captured by othercredit events — failure to pay and bankruptcy.The second outcome, depending on the circumstances, may be a ―distressed exchange‖restructuring. The third outcome — the lender receives everything it is owed — is not a default.Because the first and second outcomes are already captured by other credit events, and the thirdoutcome is not a default, it is unclear what additional scenarios this ―credit event― is intended tocapture.16 It has been suggested that the purpose of this credit event is ―timing‖ — i.e., becausemany accelerations are followed closely by either a payment default, bankruptcy, orrestructuring,17 including this event allows credit protection payments to be made earlier thanthey otherwise would. However, if the acceleration precipitates a true default, the default is likelyto occur, at most, two or three months later, and it is difficult to justify why a counterpartycannot wait until it has suffered a true credit event to be compensated.More fundamentally, an acceleration where the lender receives everything it is owed — clearlynot a ―default‖ — would trigger a credit event under the ISDA definition. While historically rare,there have been instances of bond accelerations where investors have been paid par, thus leavingthem with no loss. Moody‘s has not compiled its own data on such events, because they are not―defaults.‖ Moreover, while Moody‘s is unaware of any data with respect to accelerations ofloans and private placements, anecdotal evidence suggests that acceleration followed by totalrecovery — i.e., the lender gets all of its money back — is more common. Inclusion of―obligation acceleration‖ as a credit event would not be as problematic if the market value of anobligation is always par when the lender will be fully paid off following acceleration.If that were the case, there would never be any loss following such credit events. However, it isvery possible that the market value would come in at less than par — even if the accelerated debtis fully repaid.Another concern with ―obligation acceleration‖ is that its inclusion as a credit event may createadditional incentives. A protection ―buyer‖ that accelerates a reference obligation will be Emergence of Credit Default Swaps in India
  • 39. reimbursed regardless of the outcome. Indeed, the ―buyer‖ could get all of its money back on theloan and get additional compensation if bids on the non-accelerated debt come in at less than par.Because occurrence of the ―obligation acceleration‖ credit event is often within the protection―buyer‘s― control, the additional incentive means that the event is more likely to occur in thepresence of a swap than under normal circumstances. If the ―buyer‖ has the right to accelerate, itis more likely to exercise that right if it can receive additional compensation for doing so. Thus,any historical data regarding the likelihood of acceleration would probably understate thelikelihood of its occurring when it is covered by a swap.“Obligation Acceleration” and the Problem of Basis RiskSponsors of synthetic CDO and CLN transactions can fall under two different categories: (1)those who are credit default swap ―end users,‖ and (2) those that are not. The ―end users‖ arebuying protection on cash exposure to the reference credits. In other words, they have actualexposure to the credits through loans or other business relationships with the obligors. Sponsorsthat are not ―end users‖ are buying protection on synthetic exposure to the reference credits.They are exposed to the credits by way of credit default swaps — i.e., they are ―selling‖protection on the credits to other counterparties, and if there is a credit event on those swaps theywill be required to make a credit event payment to the other counterparties.―End user‖ sponsors recognize that ―obligation acceleration‖ is not necessary, and, unlessrequired to do so by regulators, have typically not asked for its inclusion their transactions.However, institutions that are hedging, or buying protection on, synthetic exposure have arguedthat inclusion of this event is necessary, because most of the swaps giving rise to their exposureinclude ―obligation acceleration.‖ If the synthetic CDO or CLN does not include this creditevent, there are potential loss events for which they are not hedged. Believing this additional riskto be significant, these institutions are often unwilling to take the incremental basis risk and haveasked Moody‘s to rate the transactions with this event. Moody‘s is reluctant to rate a credit eventthat is not a default and is only present because of a quirk in the ISDA definitions that hasbecome ―standard.‖ The optimal solution is to remove ―obligation acceleration‖ all together, orfor it no longer to be ―standard.‖ However, Moody‘s has been able to rate transactions includingthis event with the following modifications to the ISDA definition: Emergence of Credit Default Swaps in India
  • 40. Acceleration is only a ―credit event― if, after the later of a minimum time period and the time to the next payment date on the obligor‘s obligations, the accelerated obligation has not been fully repaid. The rationale is that if the accelerated obligation is not fully repaid by the next payment date, it will likely never be fully repaid. Following acceleration, instead of cash settlement, the protection buyer delivers to the SPV an obligation of the reference entity (1) that has been accelerated, or (2) if the delivered obligation has not been accelerated, that matures earlier than the transaction matures. The SPV would only be permitted to sell the delivered obligation if it actually defaults; otherwise, it must hold it until it matures or is paid down.21 This should remove the incremental market risk inherent in this event under a cash settled swap. Moody‘s has considered numerous alternatives to these solutions, and additional solutions may be acceptable.22 However, the best solution would be to exclude this event all together.THE PROBLEM OF “SOFT” CREDIT EVENTS: SYNTHETIC VS. CASHCredit default swaps are intended to mimic the default performance of a reference obligation.Thus, for example, owning a CLN is often considered equivalent to having a cash position in theunderlying reference obligation, except that the maturity, coupon, or other cash flowcharacteristics may be different. If an investor holds the CLN to its maturity, it should have thesame risk of loss as if it held the reference obligation to its maturity.23 Put another way, the CLNshould only default if the reference obligation defaults. However, if so-called ―soft‖ credit events— events that are not truly ―defaults‖ — are included in the swap, that will not be the case.Selling protection through a cash-settled credit default swap — e.g., owning a CLN (or asynthetic CDO) — can actually be more risky than actually owning the reference obligation(s).This is because cash-settled credit default swaps essentially force investors to ―cash out‖ of theirposition following a credit event.24 If the swap includes credit events associated with creditdeterioration short of default — e.g., a broadly defined restructuring or obligation acceleration —the CLN can default (the investor will receive less than the full part of the CLN) when thereference obligation has not.Thus, if a cash-settled credit default swap includes ―soft‖ credit events, the investor may sufferlosses that are not captured by a Moody‘s rating of the reference obligation(s), subjecting it togreater risk of loss than if it actually owned the reference obligation(s). Emergence of Credit Default Swaps in India
  • 41. MORAL HAZARDIn virtually every synthetic CDO and CLN, the ―buyer‖ of protection — the sponsoring financialinstitution — determines whether a credit event has occurred in the reference portfolio. Moresignificantly, the ―buyer‖ calculates the severity of its losses following a credit event, and howmuch the SPV will be required to pay under the swap (i.e., how much investors will lose underthe transaction). Because of the moral hazard inherent in such an arrangement, credit swapsshould be structured such that the occurrence and severity of losses can be objectively andindependently identified, calculated, and verified. Occurrence Of A Credit Event. Moody‘s generally believes that, in order for a credit event payment to be triggered, the occurrence of the event should be published in (1) a well-known news source, (2) a corporate filing, or (3) a court document. This should deter protection ―buyers‖ — acting either alone or in collusion with a reference obligor — from staging credit events for the sole purpose of being reimbursed under the swap. The rationale is that parties will be less likely to assert spurious credit events if the events have to be made public. There may be instances, however, where there is no published information available regarding a credit event. For example, the reference obligor may be a private, unrated company whose only outstanding debt is to a bank. There may be no press release, no public corporate filings, and no court documents to support the existence of the credit event. However, the sponsor should be able to get protection under the swap for that credit if there is a true default. Thus, in some limited circumstances, Moody‘s- rated synthetic CDO‘s provide that, for certain credit events, if there is no ―publicly available information,‖ at least one senior officer who is part of the sponsor‘s credit underwriting or monitoring department may provide written certification that the credit event has occurred and that the obligation has been treated internally as a defaulted asset. The certification may also contain contact information at the defaulted obligor so that the protection ―seller‖ can verify the claim and, if necessary, dispute it. Here, too, the rationale is that a sponsor is less likely to assert a spurious credit event if a senior officer who is not directly involved with the transaction is required to sign a certification that the event occurred. Emergence of Credit Default Swaps in India
  • 42. Loss Severity Following Credit Event. The amount of loss following default should becalculated either (1) by obtaining bids from third parties, or (2) by going through a formalworkout process to arrive at a workout value. The former is the most common. Because itmay not always be possible to obtain public bids, however, most transactions provide forcontingency calculation methods. These methods are often a formal appraisal by anobjective third party. The ―buyer‖ should not be the sole source for determining its lossesunder the transaction. The existence of a meaningful dispute resolution mechanism willalso help to eliminate the moral hazard inherent in these situations. In some cases,permitting investors to make firm bids — or designate other parties to make firm bids —for defaulted obligations can also be an effective solution.The Case of Blind Pools. Occasionally, because of regulatory and/or legal restrictions, abank may not be permitted to disclose certain names in a reference pool. Disclosure toMoody‘s has usually been permitted, but the bank is not permitted to disclose to investorsor others associated with the deal.25 This becomes a serious problem when a credit eventoccurs with respect to one of those names. It may be difficult to obtain a meaningful bid— and thus mark the defaulted name to market — without disclosing the name topotential bidders. The bank may also be unable to obtain an appraisal from an objective,unaffiliated third party. In these circumstances, it may be possible to get comfortable withan appraisal by the bank‘s auditors, so long as the bank retains a portion of loss (e.g.,10%) on each such name. Emergence of Credit Default Swaps in India
  • 44. Credit default swaps (CDS) are a type of insurance contracts against corporate default that aretraded in the over-the-counter market. Over the last decade, the CDS market has grown rapidlyto more than $17 trillion in notional value. Much of this development has been driven by thedemand from banks and insurance companies to hedge their underlying bond and loan exposuresand by the need of hedge funds and investment banks proprietary trading desks for more liquidinstruments to speculate on credit risk. Given the tremendous growth and the formidable size ofthe market, trading in CDS contracts can have a pervasive market-wide impact, as demonstratedby the GM/Ford credit debacle in 2005. The rapid growth and the lax regulatory supervision ofthe CDS market have raised a number of policy concerns about market stability and risk ofadverse selection, both of which would influence investors propensity to trade in the market andhence the liquidity of CDS contracts.There are a number of indications that liquidity may play a crucial role in the further growth ofcredit derivatives markets and in the pricing of these derivatives contracts. For instance, evenwith the tremendous size of the CDS market, the usage of CDS contracts by banks is stillsurprisingly low despite its obvious hedging advantage. Minton, Stulz, and Williamson (2005)that only 5% (19 out of 345) of large banks in their sample use credit derivatives. They arguethat the use of credit derivatives by banks is limited because adverse selection and moral hazardproblems make the market for credit derivatives illiquid for the typical credit exposure of banks."Parlour and Plantin (2007) show in a theoretical model that the liquidity e®ect can ariseendogenously in the credit derivative market when banks are net protection buyers. Becausebanks may utilize CDS contracts either for managing their balance sheet obligations or fortrading on their private information about the underlying, their presence in the market mayincrease the risk of adverse selection and affect the liquidity of CDS contracts. Acharya andJohnson (2007) provide evidence of informed trading in CDS contracts that highlights this risk ofadverse selection in the CDS market. In addition, several papers have documented that CDSspreads seem too high to be accounted for by default risk alone, and some have suggested thatliquidity may be a factor determining CDS prices.The effect of liquidity characteristics captures the impact of liquidity for trading today, thevariation of liquidity measures over time can pose liquidity risk that may affect future trading,and hence this liquidity risk should also be priced in CDS spreads. Emergence of Credit Default Swaps in India
  • 45. Although the liquidity effects for traditional securities, such as stocks and bonds, have beenstudied extensively in the literature,4 relatively little is known about the liquidity effects forderivative contracts, as the contractual nature of these instruments and their zero net supply inthe market distinguish them from stocks and bonds. Several recent papers have explored the roleof liquidity in pricing options. For instance, Bollen and Whaley (2004), Cetin, Jarrow, Protter,and Warachka (2006), and Garleanu, Pedersen, and Poteshman (2007) illustrate the effect ofsupply/demand imbalance on equity option prices. Brenner, Eldor, and Hauser (2001) asignificant illiquidity discount in the prices of non-tradable currency options compared to theirexchange-traded counterparts. Deuskar, Gupta and Subrahmanyam (2006) argue that there areliquidity discounts in interest rate options markets.Default Risk and CDS SpreadsCDS spreads are the required periodic payment for providing insurance for default risk of theunderlying firm. Therefore, theoretical determination of CDS spreads should capture the risk ofdefault and the potential loss upon default, similar to the credit spread for corporate bonds.Recent empirical studies, including Blanco, Brennan, and Marshall (2005), Houweling and Vorst(2005), Hull, Predescu and White (2004), and Zhu (2006), have confirmed an approximate paritybetween the CDS spreads and bond spreads. Berndt et al (2005) find that default probabilities,measured by Moodys KMVs Expected Default Frequencies (EDF), can account for a largeportion of CDS spreads. While these results imply that CDS spreads reflect well the underlyingcredit risk, Blanco et al (2005), Hull et al (2004) and Zhu (2006) also document that the CDSmarket is more likely to lead the bond market in price discovery as CDS spreads are moreresponsive to new information.A number of empirical studies of corporate bond spreads have shown that a large component ofcorporate bond yield spreads may be attributed to the effects of taxes and liquidity (see, e.g.,Elton, Gruber, Agrawal, and Mann (2001), Ericsson and Renault (2006) and Chen, Lesmond,and Wei (2007)). In contrast, it has been argued that prices of CDS contracts may not besignificantly affected by liquidity because of their contractual nature that affords relative ease oftransacting large notional amounts compared to the corporate bond market, and hence CDSspreads may better reflect default risk premium (e.g., Longstaff, Mithal and Neis, 2005). This hasled to a few studies that use CDS spreads as a benchmark to control for credit risk in order to Emergence of Credit Default Swaps in India
  • 46. study liquidity effects in bond markets (Han and Zhou (2007), Nashikkar and Subrahmanyam(2006), etc.). However, Berndt, Douglas, Ferguson,and Schranz (2005) and Pan and Singleton(2005) have documented that CDS spreads seem too high to be accounted for by default riskalone and suggested a liquidity factor as a possible mechanism for filling the gap. We discuss therole of liquidity in the CDS market in the next subsection.CDS Trading and LiquidityCDS contracts are traded over the counter in this market, an interested party searches through abroker or a dealer to find a counter-party. The two parties negotiate the terms of a contract.Information about the trade is then passed along through the back once and sent to a clearinghouse. Because the entire process has not been sufficiently standardized, there may be delays inclearing the trades. Recently, inter-dealer brokerages (IDB) have gained popularity. A dealer canregister with an IDB and use either an online trading platform or a voice quoting system. An IDBmaintains a limit order book, which substantially facilitates both the quoting and tradingprocesses. Traders can also remain anonymous until the order Is filled. Presently, CDS trading isdone through a hybrid of voice-brokered and electronic platforms.Credit default swaps allow for the transfer of credit risk from one party to another. For investorswho only want the exposure for a limited period of time, such as hedge funds, the ability to takeor remove the exposure with relative ease and at a fair price is an important consideration ofusing CDS contracts. This requires an adequate level of liquidity in the CDS market. Liquidity isan important issue for securities traded on more transparent and centralized exchanges, and it is aparticularly acute concern for CDS contracts because of their over-the-counter, non-standardizedtrading mechanics.In general, liquidity is vaguely defined as the degree to which an asset or security can be boughtor sold in the market quickly without affecting the assets price. Liquidity has multiple facets andcannot be described by a sufficient statistic. Usually, a security is said to be liquid if its bid-askspread is small (tightness), if a large amount of the security can be traded without affecting theprice (depth), and if price recovers quickly after a demand or supply shock (resiliency).Compared to other established markets, the CDS market is relatively illiquid. The bid-ask spreadis high {at 23% on average {with a sizable fixed component. The market is not continuous, asone trader has to search for another trader who can match his trade. Generally speaking, the Emergence of Credit Default Swaps in India
  • 47. aspects that affect liquidity of stocks and bonds should also affect liquidity of CDS contracts.These aspects include: adverse selection, inventory costs, search costs, and order handling costs.Acharya and Johnson (2007) find evidence indicating informed trading in the CDS market. Thisimplies that uninformed traders in the market face the risk of adverse selection.Consequently, they will seek to pay less when they buy protections and demand for more whenthey sell protections in order to compensate for the risk of trading against informed traders. Thismay also deter potential liquidity providers from participating in the market and hence increasesearch frictions and transaction costs.Inventory costs matter for risk averse dealers who also face funding constraints (Brun nermeierand Pedersen, 2007). Dealers with excessive inventory will worry about the risk of front-runningand the costs of dynamic hedging. Cao, Evans, and Lyons (2006) show that inventoryinformation can have a significant impact on prices even in the absence of changes infundamental risk, and Hendershott and Seasholes (2007) illustrate how specialists inventoryinfluences stock prices. In the CDS market, inventory can become restrictive for dealers withfunding constraints, which will in turn affect the supply of contracts in the market.Order handling costs can be substantial for CDS contracts, which may be reflected in bid-askspreads. Credit derivatives deals have so far largely been processed manually. The market isopaque and a substantial backlog is suspected. Of particular concern is the post- trade clearingand settlement process. Federal Reserve Bank of New York has requested major CDSparticipants in the U.S. to clean up their processing of derivatives trades. A survey by theInternational Securities and Derivatives Association (ISDA) shows that one in five creditderivatives trades by large dealers in 2005 contained mistakes. Even though virtually all marketparticipants are sophisticated institutional investors, the opacity of the trading mechanics in theCDS market has raised concerns about its vulnerability at the time of crisis (see, e.g., IMF(2005)).A salient feature of opaque and decentralized markets is search frictions. CDS dealers can onlyfill an order through a match with a counter-party. Even with IDBs, CDS dealers will have towait for the next trader to appear because IDBs do not take positions themselves.Search costs therefore directly affect market liquidity and market prices, as indicated in atheoretical model of OTC markets by Duffe, Garleanu and Pedersen (2005, 2006). Marketmakers in this search-based market may also have pricing power (Chacko, Jurek, and Stafford, Emergence of Credit Default Swaps in India
  • 48. 2007). The over-the-counter market in which CDS contracts are traded thus provides a goodlaboratory for investigating the effect of search frictions on asset valuation, and the impact of theinteraction between adverse selection and matching intensity on liquidity.Proxies for CDS LiquidityLiquidity in the CDS market reflects the ease with which traders can initiate a contract at anagreeable price. It is difficult to find a single summary measure to capture the various facets ofliquidity.Liquidity MeasuresVolatility-to-Volume Ratio (V2V): One aspect of liquidity is the depth, namely, the pricesensitivity to the amount of market activity, usually indicated by volume. This is the essence ofthe Amihud (2002) illiquidity measure for stock.Number of Contracts Outstanding (NOC): In the inter-dealer market of CDS contracts,inventory control may be a major concern for dealers who face funding constraints.When funding constraints become binding, the capacity for dealers to take sides in additionalcontracts is severely impaired, and this will consequently affect the liquidity of the relatedcontracts (Brunnermeier and Pedersen, 2007).Trade-to-Quote Ratio (T2Q): In a search-based market, such as the CDS market, the likelihoodof finding a trading counter-party is a measure of liquidity that directly affects the price the assetis traded at, as shown in Duffe, Garleanu and Pedersen (2005, 2006) and Chacko, Jurek, andStafford (2007).Bid-Ask Spread (BAS): Bid-ask spread is arguably the most widely used liquidity proxyin the equity market and its importance for asset prices has been established since Amihud andMendelson (1986). Emergence of Credit Default Swaps in India
  • 49. Hence the findings highlights the need of a CDS pricing model that explicitly takes liquidityeffects into account. In an over-the-counter market of derivatives contracts that are in zero netsupply, the supply curve for CDS contracts may be a function of order flows. The demand-supply dynamics are affected by search frictions, market makers pricing power, hedging costsand the risk of adverse selection that endogenously determine the liquidity of the securities andin turn their prices. While some recent studies have provided insights into this new aspect ofasset pricing dynamics, more theoretical and empirical research on this subject is certainlywarranted. Emergence of Credit Default Swaps in India
  • 50. CHAPTER – 5CREDIT DEFAULT SWAP INDEX OPTIONS Emergence of Credit Default Swaps in India
  • 51. EVALUATING THE VIABILITY OF CDSThe credit default swap (CDS) market is a large and fast-growing market that allowsinvestors to trade credit risk. Multiple derivatives on CDS currently trade over the counterincluding CDO-like tranches and options. The rise of standardized, liquid, and high-volumeCDS indexes has created the possibility of exchange-traded CDS index options. Exchange-traded options would increase liquidity in the CDS option market and allow retail andsmaller investors to trade credit risk much more easily than with current products. Theprimary users of the exchange-traded options will be speculators as existing products, such asindividual CDS or the CDS indexes, are cost-effective hedges for most players.CDS index options could be an attractive new product for the CBOE but there are severalmajor issues to overcome before exchange-traded CDS index options are viable. The mostsignificant barrier to offering exchange-traded CDS index options is the risk that the CDStrading infrastructure will fail during a credit crisis. The CBOE can mitigate, but noteliminate, this risk by carefully drafting contract provisions. The easy hedgability of CDSindex options should be attractive to market-makers but current OTC CDS option dealersmight be unwilling to support a competitive exchange-traded product. There are alsopractical barriers to the product such as SEC and index licensing issues.The proposed contract is a European option on the current on-the-run series of the NorthAmerican Investment Grade CDX. The size of the contract is one hundred times the currentspread of the underlying CDX index and the contract is settled based on the CDX spread. Inorder to lessen competition with the OTC market, the contract is sized to appeal to smallerplayers and the retail market, a new customer base for CDS options.Credit Default Swap IndexesAs the CDS market increased in importance, tradable CDS indexes arose to allow players totrade a broader spectrum of credits at a lower cost. There are two primary tradable indexfamilies: the Dow Jones CDX and the International Index Company Itraxx. Both of thecompanies have indexes for various types of debt including US investment grade, US highvolatility investment grade, US high yield, European bonds, and even emerging market bonds. Emergence of Credit Default Swaps in India
  • 52. The composition of each index is determined by member banks and a particular name remains inthe index until the CDS is triggered due to a credit event. A new index is formed periodically buteach incarnation of the index shares the majority of its names with the previous index. The DowJones US Investment Grade CDX, for example, is recreated every six months with 125 CDS. Themember banks that help compose and price the index include sixteen major international banks.Each of the member banks makes a market in the CDS index and it is freely tradable with lowbid-ask spreads of ½ to ¼ of a basis point. CDS indexes are important innovations that allowfinancial players to trade a broader spectrum of credits at lower cost and in a more liquid market.For the purposes of this paper, I will hereafter use the Dow Jones Investment Grade CDX indexas the example and that index will serve as the underlying of the proposed options.The Dow Jones Investment Grade CDX is intended to trade exposure to the credit risk of NorthAmerican investment grade firms. The index is made up of 125 of the most liquid investmentgrade credits and composition is determined by Dow Jones and the member banks. Initial creditsare all investment grade but names are not removed from a given series if the quality of a creditdecreases over time as long as the CDS protection event has not been triggered. Albertson‘sremains in the Series 5 Investment Grade CDX, for example, because the company wasinvestment grade when the index was composed but has since been excluded from Series 6 dueto its BBB- rating. The CDX is an equally-weighted index with each credit initially making up0.8% of the index although that weighting changes when a CDS is removed due to a credit event.The index is intended to reflect multiple industry sectors and provide a broad exposure to NorthAmerican investment grade creditsThe mechanics of the CDX index are fairly simple. Each year, the protection buyer pays theprotection seller the initial price of the index (for example 45 basis points) on a given notionalamount of the index. If the index value changes over the next 90 days, the protection buyer willmake a payment to the protection seller equal to the present value of change in the value of theindex over the remaining life of the contract. As a result, entering into the CDX after inceptionrequires the exchange of an up-front payment representing the probability weighted present valuedifference between the current market value of the CDX and the initial deal value of the CDX. Inaddition, upon entering the CDX the seller pays the accrued premium from the last payment dateto the settlement date in order to receive a full 90 days of premium on the next payment date. Inthe event of a triggering credit event, the index is typically physically settled. The protection Emergence of Credit Default Swaps in India
  • 53. buyer will deliver to the protection seller a face amount of the defaulted debt equal to 1/125 ofthe original notional value of the index purchased and the protection seller will deliver an equalamount of cash. After the default, the notional value of the index held is lowered by the amountof cash delivered by the seller to the buyer.OTC Credit Default Swap Index DerivativesSince the CDS indexes were introduced, an array of over-the-counter derivatives have arisenwhich permit trading of specific portions of risk. CDS indexes work very well for hedging orgaining exposure to certain specific areas of the credit market. There are now tradable CDSindexes that cover specific sectors, points on the credit curve, geographies, and credit qualities.In addition, banks offer both CDS index tranches and index options to allow speculators to tailortheir exposure to credit risk. Banks use CDX tranches to subdivide the credit risk of the 125companies in the index and sell off the pieces to different customers. Each tranche holds acertain priority in providing insurance on the basket of CDS and, thus, carries a much differentrisk profile. For example, the equity tranche will typically cover the first 3% of defaults while thejunior mezzanine tranche would cover the next 4% of defaults. This structure allows investors toleverage (invest in the equity tranche) or deliver (invest in the senior tranche) their exposure tothe credit risk of the index. The tranches are standardized and liquid and banks quote bid-askspreads daily. Trading CDX tranches allows traders to take positions on correlation betweencredit events within a CDX index or across different CDX indexes.Similarly, over-the-counter CDX options allow speculators to take a position on the volatility ofCDS market spreads. The size of the over-the-counter CDX option market is unclear. A RiskMagazine survey found that the market was only $1.5 billionExchange Traded OptionsExchange-traded options offer multiple benefits over over-the-counter options. Exchangesgreatly enhance the liquidity of the option and lower the transactions costs of trading an option.This increased liquidity frequently results in improved price discovery. Additionally, exchange-trading can allow new parties to trade an option because the exchange absorbs the counter-partyrisk of trading the options which lowers transactions costs of smaller trades. Emergence of Credit Default Swaps in India
  • 54. Exchange-traded options have many benefits but not all options can or should be exchangetraded. Exchange traded options must be traded in order for the exchange to make profits. If anoption is not expected to trade in a minimal volume an exchange like the CBOE cannotprofitably offer the option. In order to generate this trading volume and liquidity, exchangetraded options must be standardized but must also attract a wide range of potential users.Hedgers are an important user of options but are not necessary to create a successful exchangetraded option. Large hedgers greatly increase the dollar volume outstanding of an option butfrequently-trading speculators such as hedge funds are usually much more profitable for anexchange.Exchange traded options require both end users and market makers to generate the requiredliquidity. To attract the market makers required to facilitate exchange-traded option transactions,it is important that the price of the underlying asset is a transparent price and that the option ishedgeable. In this case, a transparent price is a price that reflects the actual price from a liquidmarket without significant delays or manipulation. Illiquidity or settlement lags with theunderlying asset can create significant risk for option market makers. Likewise, the marketmaker must be able to hedge their position to make a market. Market makers are not in thebusiness of taking bearing price risk and prefer to make their money on the bid-ask spread.Market makers are attracted to options that are both hedgeable and based on an underlying with areliable market price.In derivatives with a robust OTC market, it can be difficult for exchange-traded options tosucceed. Exchanges depend on dealers to generate or attract a large portion of the volume in anew product. A new product that appeals to the dealers‘ existing customer base, however, is adirect competitor and a threat to the dealers‘ profits. Despite assuring the exchange before a newproduct offering, historically dealers have not supported exchange-traded products that competedwith their robust and profitable OTC products. Due to this, successful exchange-traded productsare frequently tailored to attract a different customer base than the OTC market.Exchange-Traded CDX OptionsMarket and CustomersCDX options are a strong new product candidate for the CBOE but it is not clear that the marketin the underlying is mature enough right now. As discussed above, the CDS market is one of the Emergence of Credit Default Swaps in India
  • 55. hottest financial product markets and is expected to continue its growth in the future. Given thehistorical growth rate of the OTC CDS index options market, the current market size is estimatedat between $1 trillion and $800 million in notational amount. The Dow Jones North AmericaInvestment Grade CDX, the underlying for the proposed options, has a volume of several timesthe option market. In the very near future, the market for CDX options will clearly be largeenough to create an attractive product for the CBOE. In addition, successfully introducing thefirst exchange-traded options based on CDS will give the CBOE a significant first-moveradvantage in introducing the next generation of CDX or other CDS options.While the attractive size of the market is apparent, the composition of the users of the CDXoptions is a bit murky. The options will certainly attract speculators who want to take a positionon the volatility of credit risk but it is not clear whether a significant hedger market will develop.CDS are themselves a derivative which are used to hedge credit risk. CDS options could also beused to hedge credit risk although the options would not be as useful for hedging as theunderlying swap. As an exchange-traded option, the CDX option would necessarily be morestandardized than the custom products available in the OTC market. Therefore, CDX optionswill not be as close of a hedge for the credit risk of the vast majority of bond portfolios as acustomized OTC product. In addition, most CDS are five year contracts which can provide along-term hedge. In order to maintain high liquidity exchange-traded CDX options will likelyhave a maximum maturity of six months. Considering rollover and transactions costs, the cost ofa long-term options hedge is, therefore, unlikely to be competitive with the cost of a CDS swap-based hedge. With the lower transactions cost of the exchange-traded option, however, the CDXoption may be an attractive ―disaster insurance‖ option for shorter term hedges on portfolios thatare similar to the underlying CDX portfolio. For example, the credit risk of a diversifiedportfolio of North American investment grade credits would tie closely to movements in theCDX index. (Note that the actual bond spreads may not tie closely due to embedded options).The correlation of credit events across companies works in favor of hedging using a CDX optionas increases in the price of credit insurance are likely to be systemic, rather than fullyidiosyncratic. Therefore, the CDX options will be a better hedge for portfolios that do notperfectly match the underlying credits in the CDX because the credit risks are correlated acrossbonds. Emergence of Credit Default Swaps in India
  • 56. Pricing and Liquidity Issues of CDSThe lack of a larger hedger base of users is a minor consideration but the quality of CDS prices isa much more significant issue. The explosive growth of the CDS market has led to well-publicized issues with trade settlement as the infrastructure has not kept up with the growth ofthe market. According to the ISDA, credit derivatives as a group experienced 128% growth from2004 to 200523. Recent improvements, spear-headed by the International Swap and DerivativesAssociation (ISDA), have improved settlement efficiency. The bankruptcies of companies suchas Collins & Aikman, Delta, Northwest, Delphi, and Calpine still caused a significant settlementlag and the settlement system has not been tested by a closely-timed string of triggering eventssince the explosion in market growth. More recently, settlement in the CDS market has improvedfrom 17.8 business days in 2004 to 11.6 business days in 2005 according to an ISDA survey.According to the same survey, the trade processing error rate has fallen from 18% in 2004 butremains at an unacceptably high 9% in 2005. Much of the improvement is due to an increase inautomated trade generation from 24% to 40%. Historically trades have been done by the error-prone process of phone calls and manual order confirmations described by Alan Greenspan as a―19th century technology.‖ Given the state of CDS trade settlement, there is a significant riskthat the price of the ultimate underlying asset of the CDX options, the CDS and the CDX index,would not reflect accurate market prices during a shock to the credit markets. Pricing the CDXindexes depends on a LIBOR-like survey of the member banks and requires that these banks canproduce accurate prices for the individual CDS. The risk of poor price transparency in the CDSmarket and the risk that it would cause liquidity in the CDX option market to dry up are bothsignificant risks for market makers and potential deterrents for CDX option users.The difference in liquidity between on-the-run and off-the-run CDX indexes creates a similar butless significant liquidity issue. As discussed above, every six months Dow Jones and the memberbanks choose a new index of 125 CDS to make up the North American investment grade index.Each index is given a new series number (i.e. Series 5 for the fifth new index) while the oldseries continue trading. Ninety-plus percent of the names are carried over from series to series ofthe index but new names are brought in to the new series replace names that are no longerinvestment grade credits. The ―on-the-run‖ series is the most current series while all other seriesare termed ―off-the-run.‖ Historically, when a series goes off-the-run the volume drops after afew months as speculators switch to the more liquid on-the-run series. This drop in the volume of Emergence of Credit Default Swaps in India
  • 57. the underlying creates additional risk that the price of the off-the-run index is not a true marketprice. The CBOE could avoid this risk by initially limiting options to on-the-run CDX. Giventhe six month time between series of the index, this limitation would cut the potential maturity ofthe options down to only six months. This maturity limitation is not significant as about 70% ofthe current OTC CDS index option trading is for three month or shorter options. On the otherhand, this limitation would not allow CBOE option traders to take an option position includingmultiple CDX series. Only one CDX series is on the run at any time so options on only oneseries of CDX would trade on the CBOE at a time under the limitation. Traders often takepositions in one series of CDX versus another series and limiting CDX options to the on-the-runindex would keep that volume off the exchange. While limiting exchange-traded CDX options tothe on-the-run index will lower trading volume, it is a good initial step to temper the CBOE‘srisk and ensure liquidity.Pricing of Exchange-Traded CDX Options Despite these risks to the CDX options, under normal market conditions pricing andhedging the options for market makers and users is not difficult. There are several academicmodels to price options on individual CDS options including a SSRD model and a Black‘s-likemodel. These models require the user to estimate two unobservable variables: credit spreadvolatility and the recovery rate on the reference asset. Options on CDS indexes would alsorequire the user to estimate the correlation between the CDS in the index using historical data orcurrent CDX tranche prices. While there is no single accepted model for pricing CDX options,there are enough decent models to allow players to price and trade the CDX options. In fact thereare already software packages, such as FinCAD, that have functions for pricing CDS indexoptions. Any model of CDX options will generate an option delta that will allow a user to deltahedge the CDX options with the frequently-traded CDX index. In general, exchanges areagnostic to pricing models. Contracts currently trade on the VIX volatility index, options forwhich there is no agreed-upon pricing model and for which traders use different models. Pricingand hedging the CDX options will not be a limiting factor on the exchange-traded CDX optionmarket. Emergence of Credit Default Swaps in India
  • 58. Structure of Exchange-Traded CDX OptionsThe mechanics of exchange-traded CDX options will be different from a regular swaption,although the pricing will be similar. Settlement of a typical swaption gives the exerciser aposition in a swap if the option is exercised. The exchange-traded CDX, on the other hand, willsettle in cash based on the current spread of the CDX index. The value of the two methods ofsettlement will be exactly the same because the CDX index price is based on the market price ofthe basket of swaps in the CDX at any point. Given the potential pricing issues with CDS, another possible option is a binary contractwhich would deliver a predetermined value upon the occurrence of a stated event. One possibleexample of a stated event would be the downgrade of a certain number of names in the CDXindex. While this binary option would abstract away from CDS pricing issues, it would not be aseffective as a hedge, nor would it be as hedgable as an option based on the CDX spread. Every CBOE contract has provisions that determine settlement in the event that there isno market price for the underlying and these provisions would be critical for a CDX optioncontract. One example of such a provision is to use the closing price on the underlying from theprevious day in the event that there is no current market price. Another option is to accelerate theexpiration of the contract in the case of pricing issues. Accelerated expiration is not an attractiveoption given that it would break the market maker‘s hedge at precisely the time that the liquidityin the market has dried up. After researching existing contracts, none of the currently tradedcontracts on the CBOE present the same type of risk in the pricing of the underlying as would theCDX-based options. Carefully writing the contracts for pricing contingencies will be crucial tomitigate the risks of the exchange and the market makers in the event of a CDS pricing crisis.The sizing of the CDX options contracts is also critical to driving volume to the exchange.Individual trades of the CDX traded on the OTC market can be very large, up to and over ahundred million dollars in notional value. The exchange, however, would prefer a much smallercontract in order to enhance volume and liquidity. There is a balance in sizing because largercontracts are more attractive to institutional players while smaller contracts will appeal more tothe retail market. The CBOT‘s experience with pricing the Dow contracts shows that sizinggreatly affects the market for a contract. The initial Dow contracts were unsuccessful becausethey were too large for the retail market, $25, while the ―baby-Dow‖ contracts at $5 have tradedat a much higher volume. Emergence of Credit Default Swaps in India
  • 59. It will be difficult for the exchange to compete with the well-established OTC market forlarge institutional buyers. Retail investors, on the other hand, are not currently able to access theCDS option market. These two factors argue for sizing the CDX option contracts on the smallerside if you believe that there will be a significant retail market for the CDX options. In addition,attracting a retail market will encourage the dealers to cooperate with the launching of the newproduct. If the exchange-traded product is tailored to a different customer base, the dealers willnot see the new product as directly competitive with their OTC offerings and are more likely totrade the product. With the CDX recently trading around 40 to 60 basis points and including the100X unit multiplier for all CBOE options, an option based directly on the CDX would have acontract size of about $4,000 to $6,000. Using simplified valuation assumptions34, the premiumon this contract would be about $4.50, right in line with the below $10 premiums preferred bythe retail market.35 A contract sized directly on the CDX spread would generate a premium thatwould be attractive to the target retail market.While the notional value of a position in the CDX changes as a name is removed due to atriggering credit event, the contract value of the exchange-traded CDX contract will not change.While this will require market players to rebalance their hedges after a triggering credit eventand creates some basis risk, the added complexity in the option would likely confuse retailconsumers. The difficulty and cost of trading the liquid CDX index does not outweigh theincreased difficulty in modeling and valuing the basis-changing option. The CBOE shoulddiscuss this issue with market makers to evaluate their tolerance for handling this basis risk.Practical ConsiderationsThere are several other practical issues that the CBOE should consider in deciding whether tooffer CDX options. Dow Jones and the member banks have not yet licensed the CDX index toany exchange. In order to exchange-trade CDS index options, the CBOE would have to licenseor create a liquid index to underlie the option. Basing the options on a well-known and liquidindex is the easiest and best option but it may be difficult to convince Dow Jones to license theindex. Another potential practical issue is the regulatory hurdles that the SEC might impose.CDX options have different risks than other exchange traded products and it is likely that thereview process by the SEC could take months, if not years. With such a different risk profilefrom other products, there is no guarantee that the SEC would be willing to approve a CDS Emergence of Credit Default Swaps in India
  • 60. option product at all, especially a product partially targeted to retail customers. The tradingmethod of the contracts is another practical consideration. Electronic trading is likely to workfine with the lower-priced contracts described in the paper but many constituents prefer floortrading for larger contracts. The systems requirements for a CDX contract are not likely to be asignificant roadblock as the CDX contract could probably use the CBOE‘s existing systems.While it is beyond the scope of this paper, the CBOE should also do a break-even study todetermine the minimum volume required to break-even on the CDX contracts. This break-evenstudy, along with review of pricing and risk considerations reviewed above, could helpdetermine whether and when to introduce options based on CDX other than the North AmericanInvestment Grade index.Options on the CDX index could be an exciting new product for the CBOE if several issues areworked out. The primary barrier to introducing the options is the risk of price failure in theunderlying CDS market. The CBOE should keep a close watch on the improvements in the CDStrading infrastructure in order to assess changes in this risk. Meanwhile, the CBOE should begininitial discussions with Dow Jones on licensing and seek input from market makers, potentialcustomers, and regulators in order to further refine the design of the product. Emergence of Credit Default Swaps in India
  • 61. CHAPTER – 6CREDIT DEFAULT SWAPS, CLEARING HOUSE AND EXCHANGES Emergence of Credit Default Swaps in India
  • 62. INTRODUCTIONAs its name suggests, the payoff on a credit default swap (CDS) depends on the default of aspecific borrower, such as a corporation, or of a specific security, such as a bond. The value ofthese instruments is especially sensitive to the state of the overall economy. If the economymoves toward a recession, for example, the likelihood of defaults increases and the expectedpayoff on credit default swaps can rise quickly. The Depository Trust and Clearing Corporation(DTCC) estimates that in April 2009, the notional amount of credit default swaps outstandingwas about $28 trillion. As a result of the overall size of the CDS market and the sensitivity ofCDS payoffs to economic conditions, large exposures to credit default swaps can createsubstantial systemic risk.Because of this potential for systemic risk, some have argued that credit default swaps should becleared through central clearing counterparties, or clearinghouses. This paper analyzes themarket for credit default swaps and makes specific recommendations about appropriate roles forclearinghouses and about how they should be organized. Clearinghouses are not a panacea andthe benefits they offer will be reduced if there are too many of them. Further, clearinghouses thatmanage only credit default swaps but not other kinds of derivative contract may actually increasecounterparty and systemic risk, contrary to the assumption of many policy makers.THE MARKET FOR CREDI T DEFAULT SWAPSA credit default swap can be viewed as an insurance contract that provides protection against aspecific default. CDS contracts provide protection against the default of a corporation, sovereignnation, mortgage payers, and other borrowers. The buyer of protection makes periodic payments,analogous to insurance premiums, at the CDS rate specified in the contract. If the namedborrower defaults, the seller of protection must pay the difference between the principal amountcovered by the CDS and the market value of the debt. When Lehman Brothers defaulted, forexample, its debt was worth about eight cents on the dollar, so sellers of protection had to payabout ninety-two cents for each notional dollar of debt they had guaranteed.Although credit default swaps can be used as insurance against a default, the buyer of protectionis not required to own the named borrower‘s debt or to be otherwise exposed to the borrower‘sdefault. Emergence of Credit Default Swaps in India
  • 63. Both buyers and sellers may use credit default swaps to speculate on a firm‘s prospects. Somehave suggested that investors should not be allowed to purchase CDS protection unless they arehedging exposure to the named borrower. This argument is flawed. Buying and selling creditdefault swaps without the underlying bond is like buying and selling equity or index optionswithout the underlying security. The advantages of these activities are well understood.Eliminating this form of speculation would make CDS markets less liquid, increasing the cost oftrading and making CDS rate quotes a less reliable source of information about the prospects ofnamed borrowers.Credit default swaps are currently traded over the counter (OTC), rather than on an exchange.Each contract is negotiated privately between the two counterparties. CDS counterpartiestypically post collateral to guarantee that they will fulfill their obligations. (According to datafrom the InternationalSwaps and Derivatives Association, about two-thirds of CDS positions are collateralized.) Thecollateral posted against a position is usually adjusted when the market value of the positionchanges. For example, if the estimated market value of a CDS contract to the buyer of protectionrises— perhaps because the probability of default rises or the expected payment in the event ofdefault rises— the seller of protection may be required to post additional collateral.CLEARINGHOUSES, COUNTERPARTY RISK AND SYSTEMATIC RISKAlthough credit default swaps can be valuable tools for managing risk, they can also contributeto systemic risk. One concern is that systemically important institutions may suffer devastatinglosses on large unhedged CDS positions. Counterparty risk, which arises when one party to acontract may not be able to fulfill its commitment to the other, is also a systemic concern. Thefailure of one important participant in the CDS market could destabilize the financial system byinflicting significant losses on many trading partners simultaneously. Derivatives dealers, forexample, are on one side or the other of most CDS trades and, according to data from DTCC,dealers hold large credit default swap positions. If a large dealer fails, whether because of CDSlosses or not, counterparties with claims against the dealer that are not fully collateralized mayalso be exposed to substantial losses.The immense losses AIG suffered on credit default swaps during the current crisis (and theresulting increase in the collateral it was obligated to post) are a more vivid example of systemic Emergence of Credit Default Swaps in India
  • 64. risk. Apparently, regulators decided to subsidize AIG after its losses because they feared thatsome of AIG‘s CDS counterparties would be irreparably harmed if AIG were unable to fulfill itscommitments. Of course, financial institutions try to control their exposure to such losses, butrisk management can fail.After two counterparties agree on the terms of a credit default swap, they can ―clear‖ the CDS byhaving the clearinghouse stand between them, acting as the buyer of protection for onecounterparty and the seller of protection to the other. Once the swap is cleared, the originalcounterparties are insulated from direct exposure to each other‘s default, and rely instead on theperformance of the clearinghouse. Thus, with adequate capitalization, the clearinghouse canreduce systemic risk by insulating the financial system from the failure of large participants inthe CDS market.A clearinghouse not only insulates one counterparty from the default of another, it can lower theloss if counterparty does default. Suppose, to pick an ideal example, that Dealer A has anexposure on credit derivatives to Dealer B of $1 billion, before considering collateral. That is, ifDealer B fails, then A would lose $1 billion. Likewise, B has an exposure to Dealer C of $1billion, and C has an exposure to A of $1 billion. Without a clearinghouse, default by A, B, or Cleads to a loss of $1 billion.With clearing, however, the positive and negative exposures of each counterparty cancel, andeach poses no risk to anyone, including the clearinghouse. In practice, counterparty exposuresare to some degree collateralized. This lowers the potential losses from a default, but collateral isexpensive and only partially offsets counterparty risk.This simple example illustrates two important advantages of clearinghouses. First, by allowingan institution with offsetting position values to net their exposures, clearinghouses reduce levelsof risk and the demand for collateral, a precious resource, especially during a financial crisis.Second, by standing between counterparties and requiring each of them to post appropriatecollateral, a wellcapitalized clearinghouse prevents counterparty defaults from propagating intothe financial system.Because of these advantages, the U.S. Treasury Department has announced that in the future allcredit default swaps that are sufficiently standard must be cleared. Emergence of Credit Default Swaps in India
  • 65. Clearinghouses, however, are not panaceas. In the fight for market share, they may compete bylowering their operating standards, demanding less collateral from their customers, and requiringless capital from their members. To ensure that clearinghouses reduce rather than magnifysystemic risk, regulatory approval requires strong operational controls, appropriate collateralrequirements, and sufficient capital. Clearinghouses should be subject to ongoing regulatoryoversight that is appropriate for highly systemic institutions.Most of the systemic advantages of a clearinghouse require standardized contracts. The CDSlosses AIG suffered in the current crisis again illustrate the point. Most of their credit defaultswaps were customized to specific packages of mortgages and would not have met anyreasonable test of standardization. As a result, they would not have satisfied the requirements forclearing under any of the current clearinghouse proposals. AIG‘s failure was driven by itsconcentrated position in credit default swaps and by the fact that its huge bets were notrecognized or acted upon by either its regulators or its counterparties. Only better riskmanagement by AIG, better supervisory oversight by its regulators, or clearer disclosure of itspositions to counterparties would have prevented the AIG catastrophe, even if clearinghouses forcredit derivatives had been in place years ago.One should not conclude that a ban on non-standardized contracts is appropriate. An importantfunction of financial institutions and insurance companies is precisely to meet the needs ofindividual businesses and owners of specific idiosyncratic securities for non-standardizedcontracts. However, those institutions and their regulators must regularly evaluate and hedge thesystematic risks of their retail businesses, and not doing so was the central failure that led to theAIG fiasco. Standardized and especially indexed contracts are useful for institutions to hedge theexposures they generate from writing specific contracts for their customers, not a substitute forthat activity.Because well-functioning clearinghouses can reduce systemic risk, financial institutions shouldbe encouraged to use them to clear credit default swaps and other derivatives contracts. Banksand other regulated financial institutions should have higher capital requirements for contractsthat are not cleared through a recognized clearinghouse.Financial institutions should not be required to clear all their CDS trades. Such a requirementwould stifle innovation and possibly destroy the market for all but the most popular CDS Emergence of Credit Default Swaps in India
  • 66. contracts. Appropriate differences between capital requirements for contracts that are cleared andcontracts that are not cleared will create the right incentives for firms to internalize the costscreated by nonstandard contracts.HOW MANY CLEARINGHOUSES?Although competition created by multiple clearinghouses might lead to lower clearing fees andtechnical efficiencies, important opportunities to net offsetting credit default swaps may be lost ifclearing is scattered across several institutions. Two CDS clearinghouses in the United States andfive in Europe have already been established or proposed. It would be difficult if not impossibleto net long and short positions that are cleared through different institutions. In the exampleabove, Dealer B will be unable to net its contracts with A and C unless both contracts are clearedat the same clearinghouse.(With sufficient standardization of contracts, collateral, and risk management, netting acrossclearinghouses might be feasible, but this is not part of any of the existing proposals.)Other netting opportunities will be lost if clearinghouses are dedicated solely to credit defaultswaps. In addition to their CDS positions, the major dealers also have large positions in interestrate swaps and other OTC derivatives. Most credit default swaps are part of a master swapagreement in which the two counterparties net their aggregate bilateral exposure across multiplecontracts. If two dealers clear a CDS through the dedicated clearinghouse, they cannot net theirexposure from this contract against their exposures from other non-CDS contracts.The potential benefits from netting credit default swaps against other types of contracts are large.According to the Bank for International Settlements, dealer exposures on interest rate swaps, forexample, are about three times larger than those from credit default swaps. Research by Duffieand Zhou suggests that, given the size of these and other OTC derivatives markets in 2009, adedicatedCDS clearinghouse would actually increase average counterparty exposures. In essence, if theclearinghouse is limited to only credit default swaps, the increased opportunities to net CDSpositions within the clearinghouse are dominated by the lost opportunities to net CDS positionsagainst other derivatives contracts outside the clearinghouse. Duffie and Zhou also demonstratethat, even if the introduction of a dedicated clearinghouse reduces average counterpartyexposures, adding a second clearinghouse dedicated to the same class of derivatives must Emergence of Credit Default Swaps in India
  • 67. increase average exposures. Finally, any increase in average counterparty exposure will beaccompanied by more demand for collateral (a scarce resource) and for contributions toclearinghouse guarantee funds. (In the United States, the CME Group‘s proposal integratesclearing of credit default swaps with financial futures, somewhat mitigating this concern.However, interest rate swaps continue to trade over the counter, and current proposals do notintegrate them with CDS clearing.)In short, widespread use of a dedicated CDS clearinghouse or fragmentation of clearing acrossseveral competing institutions will reduce the opportunities to net offsetting exposures. This willincrease counterparty risk and, in turn, systemic risk.A single clearinghouse for all OTC derivatives also has drawbacks. First, the competition createdby multiple clearinghouses is likely to lead to innovation, more efficient operations, and lowercost.Second, even well-capitalized clearinghouses can fail. The failure of a clearinghouse for all OTCderivatives is likely to have enormous systemic consequences. Despite these drawbacks,regulators and lawmakers should not intentionally or unintentionally promote the proliferation ofredundant or specialized clearinghouses. The proliferation of clearinghouses would createunnecessary systemic risk by eliminating opportunities to reduce counterparty risk.EXCHANGE TRADING OF CREDIT DEFAULT SWAPS?Although clearing does not require exchange trading, some have suggested that CDS tradingshould be conducted only on exchanges, which offer clearing and superior price transparency.Because the current OTC market is relatively opaque, in many cases bid-ask spreads are likely toshrink if trading moves to an exchange. This benefit, however, should be weighed against thebenefits of innovation and customization that are typical of the OTC market.Most important, requiring exchange trading for all credit default swaps is impractical. Creditdefault swaps are traded on an enormous number of named borrowers and specific financialinstruments. DTCC provides data, for example, on the outstanding amounts of credit defaultswaps on 1,000 different corporate and sovereign borrowers. Although the most actively tradeddefault swaps, such as CDS index products, are natural candidates for exchange trading, manyless active swaps would not be viable on an exchange. Emergence of Credit Default Swaps in India
  • 68. An attractive alternative to mandatory exchange trading is regulation that improves thetransparency of trading for more active and standardized CDS contracts in the OTC market. U.S.dealers trading corporate and municipal bonds in the OTC market must quickly disclose theterms of most trades through TRACE, a reporting system maintained by the Financial IndustryRegulatory Authority. Research by Edward, Harris, and Piwowar, Goldstein, Hotchkiss, andSirri, Green, Hollifield, and Schurhoff, and Bessembinder and Maxwell suggests thatdissemination of trade data through TRACE reduces the bid-ask spreads for some importantclasses of bonds.A similar system in the CDS market would increase the transparency of trades and improve theability of participants to gauge the liquidity of the market and of regulators to identify potentialtrouble spots. Although increased transparency can in some cases limit market depth and stifleinnovation, the benefits of greater transparency for established and active standardized contractsalmost certainly exceed the costs. Industry efforts to achieve greater transparency in the CDSmarkets have been helpful and should be pursued aggressively. These efforts have improvedcompetition by increasing awareness of trade prices and volume, but they have not been assuccessful providing information about liquidity and trading costs. Serious consideration shouldtherefore be given to the introduction of a reporting system for the more active standardizedindex and single-name contracts, similar to the TRACE reporting system for corporate andmunicipal bonds. If implemented judiciously, such a system would improve the quality of themarket for these contracts. Emergence of Credit Default Swaps in India
  • 69. CHAPTER – 7CREDIT DEFAULT SWAPSAND COUNTERPARTY RISK Emergence of Credit Default Swaps in India
  • 70. INTRODUCTIONThe financial market turmoil has highlighted the importance of counterparty risk in the over-the-counter (OTC) derivative markets. The role played by credit default swaps (CDSs) has been thesubject of lively debate, with some commentators claiming that the CDS market has increased financial contagion or even proposing an outright ban on these instruments. CDSs are derivativeinstruments which enable market participants to transfer or redistribute credit risk. For example,a bank can buy CDS protection to protect itself against a default by a CDS reference entity.Given the relatively liquid nature of the CDS market, it is also a useful source of information onthe price of credit under normal circumstances.However, to an outside observer, the size of the CDS market, combined with its structuralopacity, concentration and interconnectedness, may be a sign that the CDS market also poses asystemic risk to financial market stability. Given the international nature of the CDS market,these aspects could usefully be considered from a global perspective.This Banking Supervision Committee (BSC) report aims to provide an assessment, at the EUlevel, of the sources of counterparty risk and related challenges. Areas that deserve particularattention by public authorities and market participants will also be highlighted.The CDS market is relatively small by comparison with other OTC instruments (accounting forless than 7% of the OTC market in terms of notional amounts), despite experiencing veryconsiderable growth over the last few years.Recent BIS statistics place the notional value of CDS contracts outstanding in December 2008 atover USD 41 trillion. The net mark-to-market exposure, which represents the true counterpartyrisk in the CDS market (taking into account the netting of multiple trades between pairs ofcounterparties and the relevant collateralisation) is probably a fraction of this amount, but stilldifficult to quantify with available data.Being an unregulated market, CDSs have always been opaque credit risk transfer instruments,and their effective contribution to risk dispersion has always been difficult to measure andassess. Statistics on CDS volumes have recently improved following the release of more detailedstatistics by a service provider in the CDS market in November 2008. However, the availabledata remain only loosely related to the actual credit risk and still do not provide any indication ofindividual counterparty risk exposures. Emergence of Credit Default Swaps in India
  • 71. Assessing CDS-related counterparty risk in the EU has therefore proved to be very challengingowing to the lack of information on the market value of CDS positions, on the identity ofcounterparties or on collateral practices (including the extent of collateralisation).In this regard, this report has benefited greatly from the availability of a unique set of data, inparticular data made available by 31 of the largest European financial institutions in response toan ad hoc qualitative and quantitative survey.Drawing on these data, the report sets out four main features of the CDS market in the EU thatdeserve attention for financial stability purposes. First, the CDS market remains highly concentrated in the hands of a small group of dealers, which is European banks‘ main concern as regards CDS counterparty risk. In Europe, the top ten counterparts of each surveyed large bank account for 62-72% of its CDS exposures (when measured in terms of gross market value). In addition, the concentration of the CDS market is now higher than it was before the crisis, since some major players – for instance dealers (e.g. Bear Stearns, Lehman Brothers and Merrill Lynch), or counterparties that used to be sellers of protection, such as monolines, credit derivative product companies (CDPCs) and hedge funds – have exited the market. This concentration has increased the liquidity risk in the event of another dealer failure. Market participants have also indicated concerns regarding the relative scarcity of sellers. Second, the interconnected nature of the CDS market, with dealers being tied to each other through chains of OTC derivative contracts, results in increased contagion risk. In practice, the transfer of risk through CDS trades has proven to be limited, as the major players in the CDS market trade among themselves and increasingly guarantee risks for financial reference entities. Another finding is that, on the basis of the data provided by a CDS market provider, euro area banks are currently net sellers of CDSs, although the net amount of protection sold is relatively small and relates to the reference point in time for which this data was collected (April 2009). This contrasts with the traditional net buyer position indicated by BIS data. The ―risk circularity‖ within the CDS market may be a concern for financial stability, as banks may be replacing one type of risk (i.e. credit risk) with another – counterparty risk. Third, CDSs are widely – and increasingly – used as price indicators for other markets, including loan, credit and even equity markets. Thus, these instruments are playing a Emergence of Credit Default Swaps in India
  • 72. broader role in the determination of prices. On the loan market, CDSs may have animpact on access to credit and the cost of funding, as they are now widely used by largerbanks for active credit portfolio management. Some financial institutions have CDSpremium-dependent pricing guidelines for new loans, while some credit rating agenciesmay place greater emphasis on the price discovery function of CDSs by actively offeringmarket implied ratings. In the cash bond market, investors are increasingly using CDSs asan indicator for their investment decisions. The equity and CDS markets have alsobecome more interlinked where CDS price movements have a feedback effect on theequity market. Indeed, a trading strategy commonly employed by banks and other marketparticipants consists of selling a CDS on a reference entity and hedging the resultingcredit exposure by shorting the stock. While linkages and circular feedback effects on theunderlying reference entities cannot be ruled out, comprehensive empirical studies havenot yet been undertaken to determine the strength or otherwise of those links.Fourth and finally, the report also highlights the risk factors related to the significantwidening observed in sovereign CDS spreads in mid-March 2009. Given that sovereignCDS spreads are, in most circumstances, also viewed as lower limits for the corporationsof those countries, further research is warranted to assess the causes of thesedevelopments. The potential policy implications in terms of the impact that theseexceptional CDS spreads could have on the credit ratings of sovereign governments inilliquid environments and the possibility of negative feedback loops would thus seem towarrant further research for financial stability monitoring purposes. This applies inparticular to the liquidity of this market for the purpose of ensuring market integrity. Thereport also provides an overview of a number of regulatory and market initiatives that areunder way with a view to addressing these weaknesses, including details of the latest EUconsultation for OTC derivatives (including CDSs), and reviews the various initiatives toestablish central counterparty clearing houses (CCPs) for CDSs. The potential systemicimportance of CCPs was mentioned by the Governing Council of the ECB on 27September 2001. The importance of CCPs was then confirmed on 18 December 2008,when the Governing Council stated that there was a need for at least one European CCPfor credit derivatives. Emergence of Credit Default Swaps in India
  • 73. CDS COUNTERPARTY RISK MEASURESThis section will review various measures of counterparty risk and specific attributes of eachsuch measure.GROSS NOTIONAL AMOUNTSThe notional amount of a credit default swap refers to the nominal amount of protection boughtor sold on the underlying bond or loan. Notional amounts are the basis on which cash flowpayments are calculated.The gross notional amount reported by the BIS is the total of the notional amounts of alltransactions that have not yet matured, prior to taking into account all offsetting transactionsbetween pairs of counterparties. As outlined above, gross notional amounts thus represent acumulative total of past transactions. Using gross notional amounts as an indicator ofcounterparty risk may be misleading, as many trades are concluded with a single counterparty.Once negotiated, CDSs bind both counterparties until the agreed maturity. Market participantsbasically have three choices when increasing or reducing their CDS exposures.First, they can terminate the contract, provided the counterparty agrees to the early termination.Second, they can find a third party to replace them in the contract, provided the counterpartyconsents to the transfer of obligations (―novation‖). As a third option, dealers that want tounwind or hedge their positions can also enter into offsetting transactions, sometimes (though notnecessarily) negotiated with the same counterparty as the hedged deal.The third solution is used extensively, and so the number of trades has surged, resulting in anincrease in total gross notional amounts. Indeed, this technique, by contrast with the other two,does not eliminate previous deals and instead adds them together. The end result is that externalmarket commentators tend to pay too much attention to the gross market values in relation toother measures of the real economy such as GDP, whereas net notional amounts, whereaccounted for, may be downplayed or perceived as being very low or moderate in relative termsgiven the huge gross notional amounts outstanding.NET NOTIONAL AMOUNTSHaving taken into account all offsetting transactions between pairs of counterparties (i.e.outstanding transactions relating to exactly the same reference entity – whether a specific Emergence of Credit Default Swaps in India
  • 74. borrower, a CDS index or a tranche of a CDS index), the net notional amount is the basis forcalculating the net payment obligation in a credit event. In the event of a default, the paymentmade (under cash settlement) by the protection seller is equal to:Net notional value × (1-recovery rate (%) of a reference obligation).The net notional value is thus a proxy for the contribution made by CDSs to an institution‘s riskexposure, as it represents the maximum amount of funds that could theoretically be transferredfrom the seller of protection to the buyer, assuming a zero recovery rate following a default bythe reference entity.In the case of CDSs which reference an index tranche, the net notional value represents themaximum amount of money that the seller of protection could be asked to transfer, assuminglosses exceed the tranche‘s attachment point.The DTCC provides aggregate net notional data for single reference entities. These comprise thesum of net protection bought (or sold) across all counterparties.MARKET VALUESThe mark-to-market value of a CDS on a given reporting date is the cost of replacing thetransaction on that date. The market value of a CDS is equal to the discounted value of all cashflows expected in the default leg (i.e. the payment to be made by the protection seller in the event Emergence of Credit Default Swaps in India
  • 75. that the reference entity defaults) and the fee leg (i.e. the agreed spread that the protection buyerhas to pay every quarter), taking into account the probability of the reference entity defaulting. Ifthat entity does indeed default, the market value should be equal to the notional value of theCDS, less the expected recovery value. The BIS, in its derivative statistics, defines ―gross marketvalue‖ as the value of all open contracts before counterparty or other netting.Thus, the gross positive market value of a firm‘s outstanding contracts is the sum of all thepositive replacement values of a firm‘s contracts. Similarly, the gross negative market value isthe sum of all the negative values of a firm‘s contracts.Gross market value is not an accurate measure of counterparty risk, as it does not take intoaccount the effect of netting for each pair of counterparties. However, this measure reflects thechanges that take place in trades‘ market values between the inception date and the reportingdate.NET MARKET VALUE/GROSS COUNTERPARTY EXPOSUREThe net market value is not calculated solely for dealers‘ CDS positions, but across all of theirOTC derivative positions. Thus, this measure of gross counterparty risk is not available for CDSsalone, as dealers do not manage their counterparty risk exposure by asset class. The net marketvalue across counterparties is also referred to as ―gross credit exposure‖. Counterparty riskreflects the risk of being forced to replace positions in the market were a counterparty to default,and net market values would therefore be a measure of counterparty risk, assuming there was nocollateralization. Unfortunately, however, neither gross nor net market values for CDS contractsare currently available from the DTCC.COUNTERPARTY RISK AND ISSUES FOR FINANCIAL STABILITYThis section will review the transmission channels through which CDSs may have contributed toincreases in systemic risk. CDS contracts are commonly regarded as a zero-sum game within thefinancial system, as there is always a buyer for each seller of CDS contracts, as with all otherOTC derivative contracts. The financial turmoil has shown, however, that both buyers and sellersofCDSs may suffer losses if counterparty risks materialize. Emergence of Credit Default Swaps in India
  • 76. Indeed, with CDSs, both parties are exposed to credit risk derived from the counterparty (or―counterparty risk‖), which reflects the potential for the counterparty to fail to meet its paymentobligations. In other words, counterparty risk reflects the risk of being forced to replace positionsin the market, werea counterparty to default.The replacement cost is of the same magnitude for the two counterparties concerned, but with adifferent sign. For instance, if there is a deterioration in the creditworthiness of the underlyingreference entity (i.e. spreads widen), a trade will have a positive value for the protection buyer(i.e. that buyer is ―in the money‖), as the protection it already has is now worth more.This positive value is the additional cost of conducting exactly the same trade with the originalspread. Thus, a value of USD 10 billion would mean that it was necessary for a buyer to pay anadditional USD 10 million to persuade a seller to take on the trade at the lower spread.Equally, a seller of CDS protection is ―out of the money‖ by USD 10 million, as that party wouldnow require USD 10 million to take on the original trade at the lower spread. If the seller were tothen default, the buyer would be entitled to claim from the seller the cost of replacing the trade:USD 10 million. Equally, if the buyer were to default, the seller would still be required to payUSD 10 million to the buyer.This requirement to pay even if the money is owed to the defaulting party is a legally bindingobligation under the ISDA Master Agreement. Dealers hedge market risk exposures resultingfrom a CDS by means of offsetting transactions with another party. If the second party is also adealer undertaking additional hedging transactions, a chain of linked exposures will arise inwhich the market participants know their direct counterparties, but not the parties further alongthe chain.A number of structural features in the CDS market have helped to transform counterparty riskinto systemic risk.First, the majority of the CDS market remains concentrated in a small group of dealers. Second,the case of Lehman Brothers has shown that the interconnected nature of this dealer-basedmarket can result in large trade replacement costs for market participants in the event of dealerfailures. Third, as regards the euro area banking sector, euro area banks appear to have becomenet sellers of standard single-name and index CDS contracts (although for limited amounts),which would imply exposure to market risk if there is a general increase in CDS spreads – for Emergence of Credit Default Swaps in India
  • 77. instance in the event of a dealer failing within the CDS market. Given the limited net values, thiscould change in the coming months, although the net position of euro area banks remainednegative at the end of June 2009.In addition to the shift from those institutions‘ historically net positive positions (i.e. as netpurchasers), it should also be noted that banks seem to have been net sellers of protection forsovereign CDSs, which may in some cases constitute wrong-way risk. Finally, the low levels ofliquidity resulting from the crisis and the current high levels of concentration in the market haveboth increased trade replacement costs and resulted in significant bid-ask spreads for marketparticipants, particularly for non-dealers.Concentration The results of interviews and the survey responses of market participants indicatepossible over-concentration in the sense of a scarcity of sellers. This, together with liquidity risk,is the main concern of European banks as regards CDS-related counterparty risk. A reducednumber of counterparties results in increased concentration risk and, consequently, greatersystemic risk. In the CDS market, as in other OTC markets, the major banks (i.e. dealers) trade activelyamong themselves and account for a large share of the daily turnover in these markets. Indeed,the CDS market is concentrated around a few large players. In 2008 the five largest CDS dealerswere JPMorgan, the Goldman Sachs Group, Morgan Stanley, Deutsche Bank and the BarclaysGroup (see Table 4.2). This ranking has been calculated on the basis of public fillings and seemsto be comparable to that listed in Fitch‘s 2009 derivative survey. A recent survey of U.S firms by Fitch also indicate that 96% of credit derivativesexposures at the end of Q1 2009 of one hundred surveyed firms was concentrated to JP Morgan, Emergence of Credit Default Swaps in India
  • 78. Goldman Sachs, Citigroup, and Morgan Stanley and Bank of America. According to DTCC data,the five largest CDS dealers were counterparties to almost half of the total outstanding notionalamounts as at 17 April 2009 and the ten largest CDS dealers were counterparties to 72% of thetrades. As regards BIS data, the market share of major players seems to be larger in Europe thanit is for the total global market. This, however, is explained by the difference between the BISand DTCC data in terms of scope. The quantitative survey included details of the percentage of trades that the largestdealers conducted with their ten largest clients. The results of that survey, which are similar tothe DTCC data, showed a high level of concentration in the CDS market when looking atindividual CDS-dealing banks. The survey collected both notional outstanding amounts andpositive market value positions. In principle, the latter measure is a better proxy for counterpartyrisk than notional amounts, as reflects the costs that may arise if trades with counterparties needto be replaced. The survey concluded that 62-72% of the largest EU banks‘ CDS exposures(measured in terms of gross market value) were against those banks‘ ten largest counterparts. Emergence of Credit Default Swaps in India
  • 79. Exposure relative to bank capital is higher for the largest EU banks, for which grosspositive market values account for more than 350% of their tier 1 capital, compared with 125%for the average bank in the sample. It should, however, be noted that this indicator does not takeinto account the collateral underlying these exposures. The current high levels of concentration in the CDS market probably exceed thoseobserved before the crisis, as the market has seen the exits of the independent CDS dealers BearStearns, Lehman Brothers and Merrill Lynch. This has also coincided with the reduction ofproprietary trading activities by several European banks and reduced amounts of CDSs sold byhedge funds and exits from the market by large CDS sellers such as AIG, the monolines and theCDPCs. It is difficult to demonstrate an increase in concentration using the CDS data provided Emergence of Credit Default Swaps in India
  • 80. by the DTCC, as these statistics were first published in November 2008, showing the outstandingamounts of CDS at the end of October 2008, after Lehman Brothers‘ failure. This report hastherefore used the only existing historical series available – the BIS data – to demonstrate thisreconcentration of the market and to illustrate non-bank players‘ retreat from the market sincethe crisis began. First, BIS data show that non-bank players have retreated from the CDS market since thecrisis began. At the global level, from 2005 to 2007 non-bank financial institutions accounted for12% of sales of protection to BIS dealers. This share was 10% in June 2008 and only 7% inDecember 2008. One possible explanation is that, post-crisis, significant losses have erodedcapital and the institutions‘ appetite for the selling of protection. In the non-bank sector, there arefewer active pure protection sellers. Hedge funds, financial guarantors, credit derivative productcompanies, and synthetic CDOs and SIVs are all examples of net sellers of CDSs prior to theonset of the crisis. In addition, according to some market participants, the market hasexperienced a flight-to-quality effect, which has benefited the sounder large institutions and mayhave been detrimental to the non-bank sector. Market participants have indicated that a number of hedge funds were increasinglypursuing credit-oriented strategies in the run up to the financial crisis, and that these playersaccounted for significant daily CDS trading volumes. This was also the finding of a Fitch survey Emergence of Credit Default Swaps in India
  • 81. in 2006. The level of CDS trading activity has, however, fallen sharply in conjunction withfinancial deleveraging and fund closures. A record number of hedge funds were levered less thanonce during the months of September and October 2008 in the face of investor redemptionrequests, losses, aggressive deleveraging and – potentially – reduced credit lines extended byprime brokers and increased margin calls. This, in combination with bilateral collateralmanagement procedures, may have prevented considerable concentration risk from materializingwithin the hedge fund community in relation to the CDS market. In the absence of detailed CDS-specific corporate disclosures by institutions, it is not possible to identify the losses sustained bynon-banks such as hedge funds. The reduced level of activity by hedge funds is particularly visible within BIS data,which show that the market values of the notional amounts bought and sold by hedge fundsincreased only modestly during the second half of 2008. Although the overall CDS marketdecreased owing to compression cycles, it should be noted that gross market values foroutstanding CDS contracts increased significantly for all sectors in tandem with rising marketvolatility. Hedge funds were the exception. Hedge funds and SPVs‘ share of total contracts soldto dealers is substantially lower in Europe(at 5%) than it is globally (at 7%). However, a furtherreview of the causes of this difference, including an analysis of the data quality of individualinstitutions‘ reports, is warranted. Until 2007, hedge funds sold approximately 8% of the grossnotional amount of CDSs bought by dealers. Their share then declined to stand at 5% inDecember 2008.Interconnectedness There is plenty of support in the literature for the fact that derivatives increase theinterconnectedness between banks. However, this crisis has shown at least three new interestingareas for further study in this respect. First, when the underlying reference entity for a CDS is a financial institution, thecounterparty risk effect can be substantial, as the intermediaries in the CDS market are otherfinancial institutions. In particular, the values of large global financial firms fluctuate together,owing to their interconnectedness in the global markets. The fact that such institutions are tied toeach other through chains of OTC derivative contracts means that the failure of one institutioncan substantially raise CDS spreads on other institutions, making it difficult for investors to Emergence of Credit Default Swaps in India
  • 82. separate the credit risk of the debtor from CDS counterparty risk. The need to hedge counterpartyexposures has therefore increased for risk management purposes. Second, the increasing correlation between counterparties and reference entities hasrecently taken on a new dimension in those countries whose banking sector has been supportedby public authorities. The sovereign CDS market for developed countries has surged followingthe launch of national bank rescue packages. Third, market participants which were not perceived to be key or major players within theCDS market prior to the outbreak of the crisis in terms of gross notional amounts have beenshown to be too large to fail owing to their links with other key market participants. This was thecase with AIG, for instance. AIG was ranked as the 20th largest market participant in the Fitchderivative survey in 2006, with its gross notional exposures only a tenth of the size of the grossexposures of the current largest CDS dealer. Given its position as a ―one-way‖ seller, however,AIG proved to be too systemically important for the insurance market and too interconnected tofail, which required the US Treasury to support it in order to prevent knock-on effects for thefinancial system.Risk Circularity As mentioned, the first noticeable feature is that this market has experienced increasingdemand for guarantees against the failure of financial institutions. In terms of net notionalamounts (i.e. the maximum amount at risk), six dealers were among the top ten non-sovereignreference entities at the end of July 2009, compared to seven at the end of 2008. Furthermore, a breakdown of euro area entities‘ net positions indicates that euro areabanks are net sellers for single-name financial reference entities, as well as single-namesovereign governments. Although the majority of the protection sold for financial entities relates to non-euro areareference entities, the relationships between financial players mean that these exposures deservecloser attention, as shown by the cases of Lehman Brothers and AIG.Sovereign Reference Entities And Wrong-Way Risk The increased correlation in the CDS market between reference entities and sellers ofCDS protection lessens the effectiveness of the clean transfer of risk and amplifies the effect of Emergence of Credit Default Swaps in India
  • 83. this interconnectedness. This risk, called ―wrong-way risk‖, occurs when the creditworthiness orcredit quality of a CDS reference entity is correlated with the CDS counterpart‘s ability orwillingness to pay. This wrong-way risk could, for example, apply to affiliates within the samecorporate group, but could in principle also apply to wholly separate legal entities which areexposed to similar economic or external risks. Stress testing should be used to identify anywrong-way risk in existing portfolios, with risk mitigants and/or the adjustment of capitalemployed to reflect any existing wrong-way risk.An extreme example of wrong-way risk is CDSs sold by banks on their host sovereign referencecountries. A bank benefiting from state rescue packages and then selling protection on thesovereign credit risk of the country in which that bank‘s parent company is located could beconsidered a textbook case for wrong-way risks. A bank may sell CDS protection against itsown sovereign government, although its ability to honor its commitment may be closely linkedto the financial health of that sovereign government.The bank may argue that the market‘s pricing of its host country‘s credit risk was excessivelyhigh at the time of the sale and that it is unlikely for the economic conditions faced by the hostcountry‘s central government to deteriorate to such an extent that a sovereign defaultmaterializes. It may therefore be economically attractive for the bank to sell CDSs on its hostcountry and accept exposure to this sovereign credit risk. To a certain extent, the bank could alsobe regarded as acting as a stabilizing force in the market, mitigating the effects of speculationregarding widening sovereign CDS spreads.The actual amount of outstanding wrong-way risk cannot be determined accurately withoutfurther details at trade level with regard to CDS protection sellers, CDS reference entities and theamounts bought and sold. The DTCC has conducted a review on the basis of a narrow definitionof wrong-way risk for banks which have sold CDS protection on their host governments. Thisreview shows a notional amount of €10 billion of CDS contracts being sold by banks againsttheir host sovereign governments as at 17 April 2009, of which €7 billion was sold by Europeanand Swiss banks. Although this amount may be considered relatively small by comparison with theoutstanding nominal amounts on the overall market, additional DTCC data relating specificallyto euro area banks indicate that euro area banks are currently net sellers of CDSs against euroarea governments. Emergence of Credit Default Swaps in India
  • 84. The findings of the DTCC, together with the current net positions of euro area banks,imply that euro area banks have sold CDSs not against their own host governments, but mainlyagainst other euro area countries.AIG: Too Interconnected To Fail Another example of an entity which was too interconnected and too big to fail was AIG.On 30 September 2008 the aggregate gross notional amount of credit derivatives sold by AIGwas USD 493 billion – or USD 372 billion on a net basis. This was an amount which couldpotentially affect the entire financial network. The net notional amount was almost double theaggregate net notional amount sold by all DTCC dealers combined at the end of October 2008. Nevertheless, in 2006 AIG was not ranked among the largest CDS players in Fitch‘ssurvey, having just the 20th largest gross notional amount (with net notional amounts notavailable at that time), showing that aggregate gross notional amounts are not a good measure ofrisk for financial stability purposes. Furthermore, AIG mainly sold bespoke CDS contracts,which were not covered by the DTCC data, demonstrating a gap in its data coverage which iscurrently being addressed. The public support extended to AIG Financial Products enabled its counterparties tomaintain their CDS protection. Added disclosures would have shed light on the scale of the large and concentratedexposures of several systemically important participants towards AIG. However, some banks‘responses to the qualitative questionnaire have indicated that they have since implementedindustry best practices, applying nominal maximum limits for net counterparty exposures, aswell as single-name CDSs. In addition, some banks have begun requiring the use of liquidityinputs such as bid-ask spreads in their daily portfolio reconciliation processes in order to enhancecollateral management practices, with lists of counterparts that are to be monitored closely. Thecounterparts on such lists are also monitored via their CDS spreads. However, although aninstitution‘s accumulation of concentrated exposure to the market may be mitigated by means ofprudent bilateral collateral management, such practices may not prevent the general build-up ofsystemic risk or a high degree of concentration in such risk. Added disclosures for largecounterparties and the the largest derivative exposures – i.e. those that exceed certain thresholds– would therefore be very useful in order to enable market participants to better assess their Emergence of Credit Default Swaps in India
  • 85. counterparty risk and the potential for systemic spillover effects. However, there are currently nodisclosure requirements within the FASB or IASB accounting standards with regard to the maincounterparts for derivative transactions.Liquidity Dealers play an important role in OTC derivative markets, acting both as prime brokers,taking on counterparty risk, structuring products and providing liquidity. Market liquidity is ageneral precondition for market efficiency, and a sudden worsening of market liquidity maydegenerate into a systemic crisis. One of the most pernicious threats to market participants is thusthe illusion or expectation that market liquidity will be maintained. This illusion means thatmarket participants overestimate their ability to unwind transactions or hedge their positionssmoothly and rapidly to meet requirements in unforeseen circumstances, which could, ex ante,lead them to take excessive risks. For example, in the case of AIG, it is highly unlikely thatAIG‘s counterparts would have been able to undertake novation given the total collapse of theCDO market to which AIG‘s bespoke CDS contracts were linked. The IMF (2006) indicates that narrow bid-ask spreads and high volumes may beimperfect yardsticks by which to measure secondary market liquidity. These measures aresusceptible to one-way flows (i.e. dealers only), particularly if there is a lack of diversity amongmarket participants, if search and other costs are signicant, and if the cost of holding inventorybecomes an issue with regard to the dealer‘s own funding position. Tang and Yan (2007) arguethat inventory may become restrictive for dealers in the presence of funding constraints, whichhas a knock-on effect on the supply of contracts in the market. More importantly, if the liquiditycharacteristics of these contracts vary over time and there are common liquidity shocks acrossthese markets and the underlying markets, investors may systematically price in a liquidity riskcomponent. Some researchers and rating agencies have developed liquidity scores, which mainlycombine several aspects of liquidity measures. They usually combine measures of tradeinactivity and staleness of quotes, the dispersion of mid-quotes across contributors and the sizeof bid-ask spreads, resulting in an illiquidity index (i.e. the higher the index, the lower theliquidity). A deterioration in liquidity could be observed only in the fourth quarter of 2008following Lehman Brothers‘ default. During the last quarter of 2008 CDS spreads widened veryrapidly, reflecting market participants‘ view of the increased probability of other entities Emergence of Credit Default Swaps in India
  • 86. suddenly defaulting. In this situation, the valuation and quotation of CDS prices became verydifficult, having a negative impact on liquidity within the CDS market. The illiquidity indices show that CDS liquidity is not strictly correlated with creditquality and that some credit risk has to exist in order for CDS contracts to be traded actively.However, CDS liquidity disappears if the probability of default is high, as market participantswill be less willing to provide quotes for a CDS reference entity when the probability of a defaultor a ―jump to default‖ is high for the entity in question. This is supported by the observations ofmarket participants following the collapse of Lehman Brothers. According to these availableliquidity indices, CDS market liquidity seems not to have changed significantly over time. By contrast, interviews with market participants belie this assessment. While the largestplayers do not report facing liquidity problems, smaller players do. Survey responses indicatethat standard index products such as iTraxx Main and CDX.IG and single-name CDSs with largecorporations as reference entities tend to be relatively liquid, with two-way flows. Trade sizeshave also generally been reduced, particularly for high-yield names, as some market-makers nolonger quote high-yield names. On one hand, the market currently appears to be better balanced for longer maturities,such as five and ten-year maturities. On the other hand, there has, until recently, been a lack ofbuyers for single-name CDSs with maturities of less than one year, with the exception of somereference entities with jump-to-default risk. This liquidity shortage for short maturities mayreflect liquidity constraints. The interconnectedness and high levels of concentration among asmall group of dealers in the market have helped to increase the liquidity risk for the market.This has also led to wide bid-ask spreads in the market.COUNTERPARTY RISK MANAGEMENTThe failure of Lehman Brothers and the near failures of Bear Sterns and AIG have demonstratedthe importance of counterparty risk management. This chapter discusses the challenges related tothe management of counterparty risk exposures resulting from CDSs and other OTC derivatives.It also looks at state of the art collateralization practices and provides an overview of Europeanbanks‘ counterparty risk exposures. The techniques currently used to limit, forecast and managecounterparty risk (including netting and the posting of collateral) will also be outlined. The Emergence of Credit Default Swaps in India
  • 87. section concludes with an assessment of current collateral management practices and thedifficulties encountered by European banks during the recent crisis.Counterparty Risk Management Techniques Recent work by the Counterparty Risk Management Policy Group, the Financial StabilityForum and the BIS has outlined weaknesses in the OTC derivative markets‘ ability to handle thedefault of a major counterparty and indicated a need to enhance the resilience of the marketinfrastructure. Parties to OTC transactions are highly dependent on the ongoing creditworthiness,liquidity and operational robustness of their counterparties. This is particularly true for dealers,which act as market-makers by accepting clients‘ trades and entering into matching contractswith other participants. The existence of counterparty risk – which reflects the risk embodied inthe positions that would have to be replaced were the counterparty to default – adds an additionallayer of complexity to the management of financial risks stemming from derivatives, making thedesign of hedging strategies more complex. These more advanced techniques complement thebasic counterparty risk management processes (e.g. sound due diligence and diversification),which remain a fundamental element of risk mitigation. By way of illustration, consider the verysimplest derivative contract: a forward agreement written on underlying asset ―S‖ for deliverytime ―T‖. As the pay-off function of such a contract is linear in relation to the value of S, thehedging strategy is straightforward and identical for the two counterparties, apart from the signof their hedging positions.Things change if counterparty risk is introduced into the picture, as in this case when the twocounterparties‘ ex ante contract pay-offs diverge. Namely, from the point of view of the partythat purchased the asset forward, a counterparty default equates to assuming that the purchasingparty sold its counterparty a call-type option on S, the strike price of which is equal to the agreedforward price. Exercising that option would be contingent on the counterparty being unable todelivery the asset at the contract‘s maturity, which would prevent the forward purchaser frombeing able to benefit from the potential increase in the price of S.To offset such a risk, the dealer could implement a more complex hedging strategy, taking intoaccount the probability of the counterparty defaulting over the maturity of the contract. It couldalso factor in the counterparty‘s creditworthiness when pricing the forward contract, ending up Emergence of Credit Default Swaps in India
  • 88. with a different price for each counterparty. A third solution would be to cap the value of theoptions implicitly sold to its counterparties, requesting that they pay the amount of money owedeach time the value of the forward contract exceeds an agreed threshold.In the real world, banks make use of all three options, with the collateralization of reciprocalcredit exposures arising from the evaluation of OTC derivatives being the most frequentlyadopted means of reducing credit exposures arising from transactions negotiated betweendealers.CDSs play a special role in this situation, as they are simultaneously (i) a driver of counterpartyrisk similar to other OTC derivatives, and (ii) an instrument used to hedge such a risk, as dealerstend to use CDSs to hedge against the risk of a counterparty defaulting on its derivativeexposures. Counterparty risk for the buyers and sellers of CDSs arises from the mark-to-marketchanges driven by changes in the CDS spreads of the underlying reference entity between thetime of the initial agreement and the valuation time. What distinguishes CDSs from otherderivatives is the fact that the skewed distribution of credit risk could suddenly raise theprotection buyer‘s exposure to the protection seller to very high levels, such that the latter couldsuddenly be asked to pay the former huge amounts of money, with all the resulting interlinkagesbetween counterparty and liquidity risks. This makes CDS instruments particularly significant interms of risk.Dealers can hedge such CDS-related exposures by means of offsetting transactions with anotherparty. If the second party is also a dealer, and that dealer in turn undertakes an additional hedgingtransaction, a chain of linked exposures will arise in which the market participants know theirdirect counterparties, but not the parties further along the chain. Recent market events haveshown that market participants and regulators have been unable to effectively manage creditexposures, as they have not known the actual location or level of concentration of the credit riskin question. In addition, almost all survey participants and interviewed market participants agreethat counterparty risk remains one of the main concerns of European banks. Emergence of Credit Default Swaps in India
  • 89. CHAPTER – 8 EFFECT OF CREDITDEFAULT SWAPS IN INDIAN MARKET Emergence of Credit Default Swaps in India
  • 90. RBI GUIDELINES ON CREDIT DEFAULT SWAPSReserve Bank of India (RBI) has come out with draft guidelines on Credit Default Swap(CDS)per notification dated May 2007. The guidelines could not have come at a more opportune time,as several players are waiting eagerly to get appropriate instruments to manage credit risk in theirportfolio.The guidelines initially are addressed to commercial banks and primary dealers only and thescope is limited to usage of Credit Default Swap by the banks and primary dealers for sale andpurchase of credit protection in respect of single resident reference entity. Down the line, itseems that insurance companies and mutual funds also would get to participate in the excitingfield of credit derivatives.For the uninitiated, credit derivatives are synthetic instruments for transfer of credit risk in afinancial transaction or a portfolio consisting of financial assets. Most commonly used form ofcredit risk transfer that we in India are conversant with, is securitization. Securitization has focuson selling assets with credit risk. Banks can sell their loans directly or they can securitize. Orpool together their assets with credit risk and sell parts of the pool to outside investors. Eitherway it reduces credit risk because the credit exposure is transferred to the new owner.Unfortunately, these methods are insufficient for managing the credit exposure of many financialinstitutions.Credit derivatives are financial contracts that provide insurance against credit-related losses.These contracts give investors, debt issuers, and banks new techniques for managing credit riskthat complement the loan sales and asset securitization methods.A credit derivative is usually a bilaterally entered contract. The value of the contract is derivedfrom the credit risk of the underlying like a bond, a bank loan, or some other credit instrument.The value of a credit derivative is linked to the change in credit quality of these instruments.Different variants of credit derivatives are Credit Default Swap, Total Return Swap, CreditLinked Notes, Collateralized Debt / Loan Obligations (CDO/CLO), both index tranched andbespoke, Credit Spread Options etc. CDOs on CDOs or CDO2 are new variants of creditderivatives.Since most of these are well known to most of the discerning readers, we are dwelling on thedraft guidelines of Reserve Bank of India and are submitting observations hereunder as to what Emergence of Credit Default Swaps in India
  • 91. according to us are required to be additionally addressed to make the world of credit derivativesin India more meaningful and in line with the expectation of the market:1. At the very beginning we draw attention to a statement in the draft that declares that thedocument does not supersede any previous guidelines. While this is partially true, a clearerstatement on why the draft guidelines of 2003 are not pursued to logical end could have putthings in proper perspective.2. It is not also understood as to why the scope is kept limited to Banks and PDs and that too inrespect of single resident reference entity, leaving other financial institutions and retail assetsoutside the purview. At a time when infrastructure development through public privatepartnership is encouraged and deepening and widening of debt market is spoken about, theoption is required to be extended to other financial institutions as well including but not limitedto registered NBFCs and institutions dedicated to infrastructure financing in particular.3. It is the experience of the undersigned that Public Sector Banks with overseas presence writeprotections freely in respect of Credit Linked Notes referencing to FCCBs issued by Indiancorporates in the international market. It is not clear whether the Banks will continue to bepermitted to write such protections in the international market but not in the domestic market.4. We expected RBI to appreciate the problems of NBFCs more closely and to appreciate thatnot all NBFCs that are in the business of creation of physical assets in the country are doing sofor narrow business gains. Some of them are in the business to address the gap in the physicalinfrastructure of the country that deters foreign investments to come in. Unfortunately they are inthe finishing segment of the infrastructure vertical and are not yet officially recognized asinfrastructure activities.5. It is well known that the NBFCs, particularly Asset Finance Companies run huge assetliability mismatches in their books in the absence of alternative source of funding other thancredit lines from Banks. In order to address this issue they normally enter in to bilateral deals forsale of assets or undertake vanilla securitization. Recent guidelines of RBI indirectly restrictingflow of credit to NBFC ND SI have further put such NBFCs in a spot as assets they finance arefunded at a much cheaper rate in the market than the rate at which they can raise resources fromBanks.6. In the absence of variety of players interested in loans proposed to be sold / securitized, thecounter parties are almost always banks only. Availability of CDS to NBFCs would have Emergence of Credit Default Swaps in India
  • 92. afforded some alternatives (CDOs in particular) to them to go for tranched securitization and sellthem to different players according to the risk appetite / comfort level. CDOs take a debtportfolio and partition the credit risk to suit different investors‘ demands. This is done by placinga basket of bonds into an SPV, and issuing a series of notes against the basket, whichconsecutively bears the losses on the portfolio. The arrival of the credit default swap has enabledproduct structurers to replicate cash CDO portfolios without actually using the underlying debt –the synthetic CDO.7. From the point of view of regulatory oversight also RBI would rather like to encouragesecuritization / CDOs than continuing with popular bilateral deals where isolation of assets fromthe seller (true sale) and establishing bankruptcy remoteness of seller (putting the beneficial cashflow from the sold assets beyond the reach of the transferor, or any consolidated affiliate of thetransferor, and their creditors either by a single transaction or a series of transactions taken as awhole even in the event of bankruptcy or receivership of the transferor or any consolidatedaffiliate), appear at times to be extremely di fficult and tend to vary from one legal expert toanother. Besides, tranched securitization will attract many players in to the debt market therebylending solidity to its process of maturity.8. As far as the institutional mechanism to facilitate credit derivative transaction is concerned,RBI has stopped short of announcing the initiatives they are required to take. In order to makecredit derivatives attractive, it is important that indices like the CDX and iTraxx indices arelaunched to serve as true benchmarks in credit trading. Constructed as baskets of a sample ofsingle-name default swaps with standardized maturity dates and coupons, they instantly give themarket the liquidity it needs. Understandably Indian market does not have adequate data to buildsuch indices. However, our Rating Agencies are eminently competent to provide a solution forthis going forward and a role for them should be defined in the guidelines.9. RBI may also contemplate identification and approval of select legal firms to undertake legaldue diligence and sign off on all contracts that represent transfer of credit risk whether throughsecuritization / loan sales route or through credit derivatives. At a time when Indian economy isgetting integrated and transnational are evincing interests in the Indian market, such calibrationof the institutional mechanism is felt to be essential prerequisite. In this context it may be statedthat though the guidelines have referred to ISDA Master Agreement, contemporary literaturesuggests that the ISDA is not to be taken as an omnibus solution. According to Mr. Joris Vlug of Emergence of Credit Default Swaps in India
  • 93. Zanders & Partners, ―In a more volatile world it is sensible and strongly recommended tothoroughly negotiate ISDA schedules. At least two main items in the schedule should receivespecial attention. One is the fact that the parties (especially corporates) tend to forget that atrigger for a termination event in an ISDA schedule automatically triggers other funding facilitiesthrough the cross default sections in those funding facilities. The second concern is the tendencyof banks to propose a schedule, which is not realistic from the other partys point of view, eitherdue to stringent covenants or unrealistic terms and conditions. Remember one important thing:an ISDA Agreement is a bilateral agreement, so you must negotiate thoroughly.‖ Select legalfirms may give necessary consultancy in this context and enable deals to go through without anydoubt about their enforceability, particularly when the concept of ‗restructuring‘, ‗modifiedrestructuring‘ and ‗modified modified restructuring‘ as default events create some doubts /haziness.10. Besides, taking a cue from SOX (Sarbanes Oxley) compliance requirements, RBI might aswell obligate entities using credit derivatives to induct in their Audit Committees with at leastone independent financial expert who is conversant with derivatives and derivative accounting.Such members along with others in the Audit Committee, may be requested to examine internalcontrols at a desired level of detail (e.g., about the structure of derivatives, the risks they hedge,the model used for their mark-to-market, their hedge effectiveness over time, the managementand procedural controls between the front and back offices, and the conformance with tradingpolicies and limits etc). It is stated ―treasurers who are infrequent users of derivatives may nothave adequate systems, controls and processes in place. They may also be unaware of theleverage implicit in the transactions, and could end up with transactions that have a hugenegative impact on their financial statements. The identified expert in the AuditCommittee should develop a statement that specifies what hedging techniques and instrumentsshould be used to support strategy. This involves de tailed descriptions of the risk appetite,forecasted transactions, partial term hedges and other issues. Without it the risk policy is oftenleft to the whims of treasury officials, who could pursue policies that are at odds with the boardswishes.‖11. RBI has rightly prescribed that banks should address issues regarding conflicts of interestwhile structuring CDS. For that matter it is equally important for securitization and other creditderivatives too. Like in treasury operations, the concept of middle office is equally important in Emergence of Credit Default Swaps in India
  • 94. credit derivative transactions. In this context the prescription given by Mr. Joel Bessis in thefollowing statement is worth recalling: ― Even though banks have always followed well-knowndiversification principles, classical emphasis of credit analysis is at the transaction level.Portfolio analysis that has significant potential to improve risk return trade off calls forseparation of origination from portfolio management.‖12. Lastly, given the fact that process automation in different banks and PDs are at differentlevels of maturity, giving across the board authority level to write protection might not be freefrom risks. The more comprehensive the process automation is the lesser is the degree ofoperational risk. Hence a benchmark requirement of process automation could have been mademandatory for writing derivative contracts. While concluding, we draw attention to therecommendations of the Joint Forum of Basel Committee on Banking Supervision (BCBS) onthe issue of Credit Risk Transfer (CRT) in October 2004. BCBS proposes that any CRT / playerin CRT space should satisfy the following tests:1. Whether the instruments/transactions accomplish a clean risk transfer,2. The degree to which CRT market participants understand the risks involved, and3. Whether CRT activities are leading to undue concentrations of credit risk inside or outside theregulated financial sector. It has also been stated, ―some transactions are not really intended totransfer a large portion of credit risk in the first place. For example, some structured transactionsmay only transfer the ―catastrophic‖ risks associated with the most extreme set of portfoliooutcomes; these risks may be more macroeconomic than credit events. It is therefore importantthat all participants have a good understanding of the relevant transactions and the circumstancesin which they do and do not transfer credit risk.‖ Emergence of Credit Default Swaps in India
  • 95. CHAPTER – 9CASES ON CREDIT DEFAULT SWAPS Emergence of Credit Default Swaps in India
  • 96. Falling Giant: A Case Study Of AIGWhat was once the unthinkable occurred on September 16, 2008. On that date, the federalgovernment gave the American International Group - better known as AIG (NYSE:AIG) - abailout of $85 billion. In exchange, the U.S. government received nearly 80% of the firm‘sequity. For decades, AIG was the worlds biggest insurer, a company known around the worldfor providing protection for individuals, companies and others. But in September, the companywould have gone under if it were not for government assistance.The decline of AIGs financial condition can be traced back to March 2005, when the companysLongstanding AAA credit rating was reduced to AA+ following the resignation of HankGreenberg, AIGs longstanding CEO. According to Standard and Poors, the downgrade resultedin part from the companys involvement in a number of questionable financial transactions and a"revised assessment of AIGs management, internal controls, corporate governance and culture."The questionable financial transactions included certain reinsurance transactions that weresubsequently questioned by the SEC.High FlyingThe epicenter of the near-collapse of AIG was an office in London. A division of the company,entitled AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of Americancapitalism. For years, the AIGFP division sold insurance against investments gone awry, such asprotection against interest rate changes or other unforeseen economic problems. But in the late1990s, the AIGFP discovered a new way to make money.A new financial tool known as a collateralized debt obligation (CDO) became prevalent amonglarge investment banks and other large institutions. CDOs lump various types of debt - from thevery safe to the very risky - into one bundle. The various types of debt are known as tranches.Many large investors holding mortgage-backed securities created CDOs, which includedtranches filled with subprime loans. (For more on this concept, check out ourSubprime MortgageMeltdown special feature.) Emergence of Credit Default Swaps in India
  • 97. The AIGFP was presented with an option. Why not insure CDOs against default through afinancial product known as a credit default swap? The chances of having to pay out on thisinsurance were highly unlikely, and for a while, the CDO insurance plan was highly successful.In about five years, the divisions revenues rose from $737 million to over $3 billion, about17.5% of the entire companys total. (Read Credit Default Swaps: An Introduction to learn moreabout the derivative that took AIG down.)One large chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that what it insured would never haveto be covered. Or, if it did, it would be in insignificant amounts. But whenforeclosures rose toincredibly high levels, AIG had to pay out on what it promised to cover. This, naturally, caused ahuge hit to AIGs revenue streams. The AIGFP division ended up incurring about $25 billion inlosses, causing a drastic hit to the parent companys stock price. (Read more about the lead-up tothe credit crunch in The Fuel That Fed The Subprime Meltdown.)Accounting problems within the division also caused losses. This, in turn, lowered AIGs creditrating, which caused the firm to post collateral for its bondholders, causing even more worriesabout the companys financial situation. It was clear that AIG was in danger of insolvency. Inorder to prevent that, the federal government stepped in. But why was AIG saved by thegovernment while other companies affected by the credit crunch werent? (Read about onecompany that didnt survive financial crisis in The Rise And Demise Of New Century Financial.)To Big To saleSimply AIG was considered too big to fail. An incredible amount of institutional investors-mutual funds, pension funds and hedge funds - both invested in and also were insured by thecompany. In particular, many investment banks that had CDOs insured by AIG were at risk oflosing billions of dollars. For example, media reports indicated that Goldman Sachs (NYSE:GS)had $20 billion tied into various aspects of AIGs business, although the firm denied that figure.Money market funds - generally seen as very conservative instruments without much riskattached - were also jeopardized by AIGs struggles, since many had invested in the company, Emergence of Credit Default Swaps in India
  • 98. particularly via bonds. If AIG was to become insolvent, this would send shockwaves throughalready shaky money markets as millions of investors - both individuals and institutions - wouldlose cash in what were perceived to be incredibly safe holdings. (To learn more about the roughtimes money market funds saw, read Why Money Market Funds Break the Buck.)However, policyholders of AIG were not at too much risk. While the financial-products sectionof the company was facing extreme difficulty, the vastly smaller retail-insurance componentswere still very much in business. In addition, each state has a regulatory agency that overseesinsurance operations, and state governments have a guarantee clausethat will reimbursepolicyholders in case of insolvency.While policyholders were not in harms way, others were. And those investors - from individualslooking to tuck some money away in a safe investment to hedge and pension funds with billionsat stake - needed someone to interveneStepping InWhile AIG hung on by a thread, negotiations were taking place among company and federalofficials about what the next step was. Once it was determined that the company was too vital tothe global economy to be allowed to fail, the Federal Reserve struck a deal with AIGsmanagement in order to save the company.By November 2008, the company was almost entirely dependent on the Federal Reserve and theTreasury for funding. According to Federal Reserve data, AIG had borrowed a total of almost$128 billion by the end of the year. $40 billion from a bridge loan designed to help the company continue operating while it sells off non‐core assets; $28 billion to purchase the collateralized debt obligations on which AIGFP had sold protection. $20 billion of the $22.5 billion allotted to purchase subprime mortgage backed securities in which AIG had invested as part of its securities lending program (note: these are not the only mortgage backed securities in which AIG invested); and $40 billion capital investment through the TARP program. Emergence of Credit Default Swaps in India
  • 99. As these figures show, most of the federal "bailout" funds were directed at enabling the company to Continue to fund its activities and not directly related to losses incurred in connection with AIGs credit default swaps. The Federal Reserve was the first to jump into the action, issuing a loan to AIG in exchange for 79.9% of the companys equity. The total amount was originally listed at $85 billion and was to be repaid over two years at the LIBOR rate plus 8.5 percentage points. However, since then, terms of the initial deal have been reworked. The Fed and the Treasury Department have loaned even more money to AIG, bringing the total up to an estimated $150 billion. (Learn how these two agencies work to stabilize the economy in tough times in The Treasury And The Federal Reserve.ConclusionAIGs bailout has not come without controversy. Some have criticized whether or not it isappropriate for the government to use taxpayer money to purchase a struggling insurancecompany. In addition, the use of the public funds to pay out bonuses to AIGs officials has onlycaused its own uproar. However, others have said that, if successful, the bailout will actuallybenefit taxpayers due to returns on the governments shares of the companys equity.No matter the issue, one thing is clear. AIGs involvement in the financial crisis was important tothe worlds economy. Whether the governments actions will completely heal the wounds or willmerely act as a bandage remedy remains to be seen. Emergence of Credit Default Swaps in India
  • 100. CONTAGION IN THE CREDIT DEFAULT SWAP MARKET: THE CASE OF THE GMAND FORD CRISIS IN 2005ABSTRACTHas the General Motors (GM) and Ford crisis in 2005 spread to the whole credit default Swap(CDS) market? To answer this question, we study the correlations between CDS Premia, byusing a sample of 226 CDSs on major US and European firms. We show that Correlationssignificantly increased during the crisis, especially in the first week. We also test the linksbetween markets at the firm level, using VECM and VAR models. The lead of CDS market overthe bond market appears to have weakened during the crisis. The links with the equity marketwere also mitigated.INTRODUCTIONAre credit derivatives markets particularly vulnerable to contagion effects? Is a crisis likelyspread rapidly on these markets? The sharp increase in credit default swap (CDS) premia duringthe crisis of summer 2007 tends to suggest this. These questions are important given thatderivatives markets play a key role in asset pricing.Analyzing the GM and Ford crisis in 2005 enables us to tackle these issues. This event hadimportant consequences on the credit market due to the huge size of the two leadingmultinational firms. Considering this precise crisis has also the advantage of being wellcircumscribed in time, as the origin can be clearly identified. At that time, the CDS premia andbond spreads of both firms posted a sharp rise in the wake of their financial difficulties.The whole of the CDS market was affected, as well as the bond market.Contagion on financial markets can be broadly defined by a simultaneous drop in asset prices,triggered by an initial fall in one specific market. The rationales for contagion have beenabundantly studied in the economic literature (Masson, 1998; Kaminsky and Reinhart, 2000;Kumar and Persaud, 2001; Coudert and Gex, 2008). They are basically linked to the uncertaintyabout the fundamental value of financial assets: a crisis in one market can convey informationabout the other asset prices and lead investors to revise their price expectations downwards;portfolio management can also contribute to spread crises through rises in the value at risk,pushing investors to liquidate risky positions simultaneously; a crisis could also trigger an Emergence of Credit Default Swaps in India
  • 101. increase in investors‘ risk aversion… Whatever the theoretical mechanisms at stake, contagionphenomena are generally characterized by increased correlations between the prices of riskyassets, while risk-free assets benefit from a ―flight to quality‖, raising their relative price. In fact,the rise in correlations is frequently considered as the key symptom of contagion (Baig andGoldfajn, 1998; DeGregorio and Valdes, 2000).That is why we set out to test the hypothesis of an increase in correlations between the CDSsduring the GM and Ford crisis. To do so, we construct a sample of 224 CDSs of European andUS firms included in the major indices (CDX and iTraxx). We calculate correlations usingdifferent methods in order to cross-check the results. We first compare the correlations duringthe crisis period with those during a reference period, by adjusting them to take account of therise in volatilities, as recommended by Boyer et al. (1999) and Forbes and Rigobon (2001). Thismethod gives a first insight, but has its limitations because the period under review must besufficiently long to include a sufficient number of observations. However, the CDS market‘sresponse to the GM and Ford crisis was very prompt. We therefore calculate conditionalcorrelations by using Exponentially Weighted Moving Averages (EWMA) and DynamicConditional Correlation Generalized Autoregressive Conditional Heteroskedasticity (DCC-GARCH). Then we test for their increase in the crisis period.THE GM AND FORD CRISIS AND THE CDS MARKETStylised factsThe difficulties encountered by GM and Ford started to raise concerns in March 2005. On 16March, GM announced a profit warning for the first quarter, forecasting a loss of roughly USD850 million, compared to a previous target of breakeven. This would reduce the earnings pershare to USD 2, i.e. half what had been forecasted (USD 4 to USD 5). On 8 April, Ford alsoannounced a profit warning, revising its annual earnings expectations down by 25% compared toforecasts i.e. USD 2.5 billion instead of USD 3.4 billion. As a result, investors started to expectmajor difficulties and reassessed both firms‘ default risk, in March 2005, before their ratingswere actually downgraded by rating agencies4. The CDS premium of GM climbed from 304 to567 bp in March 2005, while that of Ford rose from 244 to 357 bp (Chart 1). The ratings of bothfirms were successively downgraded by the three major rating agencies between 5 May and 19 Emergence of Credit Default Swaps in India
  • 102. December 2005 (Table 1). The downgrading was particularly harsh since the two firms weredownshifted from investment grade to speculative grade. GM and Ford CDS premia continued toincrease over this period. Emergence of Credit Default Swaps in India
  • 103. Given the importance of these two firms, investors probably reassessed the risks attached to allborrowers. At any rate, all of the CDS market was affected: index premia almost doubled inMarch 2005 (Chart 2). After having reached a peak on 18 May, the CDS indices started todecline, which suggests that the market had managed to absorb the shock. Emergence of Credit Default Swaps in India
  • 104. Identification of the crisis periodBecause financial crises are generally characterised by a rise in volatility, we measure thevariations in the volatility of CDS premia for GM and Ford in order to identify the crisis periodmore accurately. We use an EWMA volatility (Exponentially Weighted Moving Average) whichis defined as the weighted sum of quadratic yields5 with exponentially decreasing weightingsover time (J.P. Morgan, 1996). The results show a sudden increase in volatility on 16 March2005 (Chart 3). This date, which coincides with the profit warning announced by GM, marks thestart of the crisis. CDS volatility rose by a factor of 3.5 between 15 and 18 March in the case ofGM (jumping from 32% to 110%) and almost twofold in the case of Ford (climbing from 30% to56%). Volatility remained high until end-August 2005. We consider that the crisis periodcorresponds to this period of pronounced volatility. It started on 16 March 2005 and ended on 24August 2005, when the two firms were downgraded by Moody‘s and when volatility had alreadynotably decreased. It is possible to identify three sub-periods:1. A reference period just before the crisis, when premia were particularly low. This period isarbitrarily defined as running from 15 December 2004 to 15 March2005 (3 months);2. The crisis period, from 16 March to 24 August 2005;3. The post-crisis period, running from August 2005 to February 2007, i.e. prior to theturbulences of summer 2007. Emergence of Credit Default Swaps in India
  • 105. The behaviour of the CDS market around the time of the crisisDuring the reference period, i.e. just before the crisis (15 December 2004 – 15 March2005), CDSpremia were particularly low and stable: 33 bp on average for the CDS IG index and 73 bp forour global index (Table 2). During this period, default rates were low and investors‘ risk appetitewas high. Then, during the crisis, CDS premia posted a sharp increase in all sectors, reaching 94bp in the case of the global index.CDS volatility rose sharply during the crisis, jumping on average from 42% to 60%. The wholeautomotive industry was affected, with volatility increasing threefold between the first twoperiods. The European and US high yield segment were also impacted. Emergence of Credit Default Swaps in India
  • 106. Stock prices of GM and FordThe crisis hardly impacted the equity prices of GM and Ford, probably because they had alreadybeen falling for a long time. Prices hit a low point on 21 and 22 April 2005 for GM and Fordrespectively (Chart ); they then picked up slightly until early May, before dropping again. In thecase of GM, prices even rose during the crisis following the tender offer made by KirkKerkorian.While the equity prices of GM and Ford were not directly affected by the crisis, their volatilityincreased in line with that of CDSs (Chart 10). In the case of GM, volatility peaked right at thestart of the crisis period, on 17 March 2005, jumping from 19% to 61% in one day. A secondvolatility peak occurred on 5 May, the day on which the ratings of GM and Ford weredowngraded. Volatility then stood at 74%. Price volatility increased to a lesser extent in the caseof Ford. Volatility peaked at 45% on 5 May, rising up from 16% at the end of the pre-crisisperiod. Average volatilities for GM and Ford increased sharply between the pre-crisis period andthe crisis period (from 17% to 46% for GM and 17% to 32% for Ford) Emergence of Credit Default Swaps in India
  • 107. The empirical relationship between CDSs and stocksWe now study the empirical relationship between CDSs and stocks. Up to now, research on thelinks between these two markets has yielded mixed results. According to Byström (2005),information is first embedded into stock prices, in Europe. Acharya and Johnson (2007) concludethat there is a continuous flow of information from the CDS market to the stock market, whenanalysing a sample of 79 US firms. Scheicher (2006) highlights the existence of simultaneous Emergence of Credit Default Swaps in India
  • 108. linkages between the two markets but does not detect any lagged effects when using a sample of250 North American and European firms.CONCLUSIONIn this paper, we analyze the possible contagion of the crisis experienced by General Motors andFord in May 2005 to the whole CDS market. At that time, both firms‘ CDS premia increasedsharply and all other CDS premia rose markedly for US and European firms. As contagion isoften characterized by increasing correlations between risky assets, we study the changes in thecorrelations between CDS premia around the time of the crisis, by calculating them throughdifferent measures. To do so, we construct a sample of 226 CDSs that are representative of theUS and European indices (CDX and iTraxx). The estimated correlations increased significantlyduring the crisis, especially in the first week, which suggests contagion phenomena. Both the USand the European markets were affected. Their similar response points to the strong internationalintegration of the credit markets.Usually, CDSs premia are close to bond spreads, but the relationship between the bond marketand the CDS market is affected by the crisis. Our results confirm that the CDS market leads thebond market in the price discovery process, which has been evidenced in previous papers. Inother words, bond spreads tend to adjust to the innovations on the CDS market, and not thereverse. However, the crisis mitigated this leading position of the CDS market. Especially, GMand Ford‘s CDS premia surged well above their bond spreads.The links to the equity market were also disrupted. We find that the two markets are usuallylinked by a negative relationship, the equity market being the leader. However, they weresomewhat decoupled during the crisis. Indeed, many stock prices continued to rise during thecrisis, while CDS premia were surging for the same firms. Therefore, contagion seemed confinedto the CDS market. The speculative nature of the CDS market may be at stake in thisphenomenon. Emergence of Credit Default Swaps in India
  • 109. Credit Default Swap by Tata to acquire Corus GroupOn 20 October 2006 the board of directors of Anglo-Dutch steelmaker Corus accepted a $7.6billion takeover bid from Tata Steel, the Indian steel company. The following months saw a lotof negotiations from both sides of the deal. Tata Steels bid to acquire Corus Group waschallenged by CSN, the Brazilian steel maker. Finally , on January 30, 2007, Tata Steelpurchased a 100% stake in the Corus Group at 608 pence per share in an all cash deal,cumulatively valued at USD 12.04 Billion. The deal is the largest Indian takeover of a foreigncompany and made Tata Steel the worlds fifth-largest steel group.The involved companies are: Tata Steel, formerly known as TISCO (Tata Iron andSteel Company Limited), was the worlds 56th largest and Indias 2nd largest steel company withan annual crude steel capacity of 3.8 million tonnes. It is basedin Jamshedpur, Jharkhand, India. [1] [2] It is part of the Tata Group of companies. Post Corusmerger, Tata Steel is Indias second-largest and second-most profitable company in private sectorwith consolidated revenues of Rs 1,32,110 crore and net profit of over Rs 12,350 crore duringthe year ended March 31, 2008. [3][4]. The company was also recognized as the worlds best steelproducer by World Steel Dynamics in 2005. The company is listed on BSE and NSE; andemploys about 82,700 people (as of 2007).Corus was formed from the merger of Koninklijke Hoogovens N.V. with British Steel Plc on 6October 1999. It has major integrated steel plants at Port Talbot, South Wales; Scunthorpe,NorthLincolnshire; Teesside, Cleveland (all in the United Kingdom) and Ijmuiden in the Netherlands.It also has rolling mills situated at Shotton, North Wales (whichmanufactures Colorcoatproducts), Trostre in Llanelli, Llanwern Newport, SouthWales, Rotherham and Stocksbridge, South Yorkshire, England, Motherwell, NorthLanarkshire, Scotland, Hayange, France, andBergen, Norway. In addition it has tube millslocated at Corby, Stockton and Hartlepool in Englandand Oosterhout, Arnhem, Zwijndrecht and Maastricht in the Netherlands. Group turnover for theyear to 31 December 2005 was £10.142 billion. Profits were £580 million before tax and £451million after tax.Proposed funding of the Deal Emergence of Credit Default Swaps in India
  • 110. Tata surprised the credit default swap segment of the derivative markets by deciding to raise$6.17bn of debt for the deal through a new subsidiary of Corus called Tata Steel UK, rather thanby raising the debt itself. Tatas security credit rating is investment grade, whereas the newsubsidiary may not be. The higher risk associated with raising debt through a subsidiary with alower credit rating prompted Fitch Ratings to downgrade its rating of the credit swap risks in thetakeover to negative. Fitch also stated that Corus responsibility for the debt may lead to Corusown unsecured debt rating being downgraded. This does not affect the rating of bonds issued byCorus which are secured debt.Mumbai-based Tata blindsided traders when it decided to borrow as much as $6.17 billionthrough a non-investment-grade Corus subsidiary to fund the takeover of the largest U.K.steelmaker. Tata, whose debt is rated investment grade, is using high-yield high-risk loans andbonds, prompting Fitch Ratings to change its assessment of the merger to ``negative, with awarning it may downgrade the securities of London-based Corus.Many traders who sold credit-default swaps on the assumption that a takeover would becompleted with an investment-grade financing are losing money on the deal. Since Oct. 20,credit- default swaps based on $2 billion of Corus debt have climbed 21 percent. An increaseindicates a worsening in the perception of credit quality. The contracts, based on bonds andloans, are used to speculate on a companys ability to repay debt.``Its clear that this came as a surprise to a certain part of the market, said Graham Neilson, afund manager at Credaris in London, which oversees $1.6 billion of assets.Fitch said the plan to make Corus responsible for the additional borrowing may prompt it to cutthe companys senior unsecured credit rating from B+, four levels below investment grade. High-yield debt is rated Ba1 or lower by Moodys Investors Service and BB+ or lower by Standard &Poors or Fitch.More Flexible Emergence of Credit Default Swaps in India
  • 111. ``The combination of the two businesses at first seemed positive for Corus; now its not clearwhat kind of access Corus will have to financial support to service the debt and to Tatas strongeroperations, said Peter Archbold, a London-based analyst at Fitch.Tata is seeking to create the worlds fifth-largest steelmaker through its $8 billion acquisition ofCorus, formerly British Steel Plc. The deal would be the industrys second biggest this year,behind Rotterdam-based Mittal Steel Co.s $38.3 billion purchase of Arcelor SA in Luxembourg.``The proposed financing ensures financial flexibility of Tata Steel to fund projects ``whileaddressing the issues of risk, Koushik Chatterjee, Tata Steels vice president of finance, said inan e-mail, without providing details.Tata Steel, Indias second-biggest steelmaker, has expanded in Southeast Asia by buyingThailands Millennium Steel PCL and Singapores NatSteel Ltd. in the past two years.``The funding structure of the acquisition of Corus may suggest that Tata Steel may want topursue further expansion, said Roberto Pozzi, an analyst at Societe Generale SA in London.`Caught OutCredit-default swaps based on Corus debt were quoted today at 162,000 euros, up from 133,800euros on Oct. 19. The prices are based on 10 million euros of debt. The five-year contracts,conceived to protect bondholders against default, pay the buyer face value in exchange for thenotes should the company fail to adhere to its debt agreements.Derivatives are financial instruments derived from stocks, bonds, loans, currencies andcommodities, or linked to specific events like changes in the weather or interest rates.``This has caught the market out, said Marwan Dagher, HSBC Holdings Plcs London-basedhead of credit sales to hedge funds. ``The lesson here is that whenever an acquisition is about tohappen, you shouldnt go out and take a view on credit quality improving because ``there aremany ways to finance these. Emergence of Credit Default Swaps in India
  • 112. The debt, to be issued under the new name Tata Steel U.K., will rely on Coruss revenue forpayment, Fitch said in its Oct. 20 report. It includes a 1.35 billion-pound ($2.5 billion) high-yield loan that will be repaid with a bond once Corus shareholders approve the acquisition, said abanker working on the transaction who asked not to be identified.Higher CostsCorus will pay interest on its loans between 1.5 and 2 percentage points above the Londoninterbank offered rate, a benchmark for lenders, said a banker involved in the deal, who declinedto be named because the information hasnt been publicly disclosed. Thats about five times theinterest margin of 0.34 percentage point that Tata is paying on a $750 million seven-year loantaken out earlier this month, said an arranger of that deal.The planned bond sale is likely to cost Corus annual interest of about 2.64 percentage pointsmore than benchmark government debt with similar maturities based on a B rating from Fitch,according to data compiled by Merrill Lynch & Co. The spread is 1.87 percentage points morethan Tata would pay, based on its Baa2 rating from Moodys and BBB ranking from S&P. Theadditional annual interest would cost the company at least $47 million, according to datacompiled by Merrill and Bloomberg.Competitors for CorusTatas planned acquisition may face competition. Companhia Siderurgica Nacional SA, aBrazilian steelmaker, hired New York- based investment bank Lazard Ltd. to advise on apossible bid for Corus, the Sunday Times in London reported on Oct. 22, without saying where itgot the information. Russias OAO Novolipetsk Steel may also bid for the company, theFinancial Times reported on Oct. 18.``There is no 100 percent certainty that the deal will go through, as another bidder could emergeor the current offer could be rejected, said Pozzi at Societe Generale.Moodys, which ranks Coruss senior unsecured debt at B1, said on Oct. 23 it hadnt yet decidedwhether to revise its ranking. S&P hasnt issued a report on Corus since an Oct. 18 statement thatthe acquisition was likely to boost Coruss BB- credit ratings ``given the higher ratings for Tata. Emergence of Credit Default Swaps in India
  • 113. ``If they were prepared to just merge the whole thing, the debt would be rated a similar way asTata Steel, and it would probably be somewhat cheaper for them to do, said Rick Mattila, acredit analyst at Dresdner Kleinwort in London.Bond BuybackCoruss bonds have gained since the takeover offer because Tata said it will buy them back.Coruss 800 million euros of 7.5 percent notes due in 2011 increased to 108 percent of face valuefrom 105 percent last month, according to RBC Capital Markets Ltd. The bonds yield 5.56percent, or 1.78 percentage points more than benchmark government debt with the samematurities.``For the bonds its fairly straightforward, theyre going to get bought back, said Robert Jones,head of high-yield research at Barclays Capital in London. ``The way the financing is structured,the credit-default swaps could end up being a lot wider than they are now. Emergence of Credit Default Swaps in India
  • 114. CONCLUSIONThe Reserve Bank of India (RBI) has taken the first step towards introducing credit defaultswaps (CDS) to India‘s financial markets by sending out feelers to a number of banks with aview to gauging the acceptability of CDS contracts. The questionnaire sent by RBI to the banksenquires about bankers‘ expectations from the derivative instrument. Although CDSs for theIndian companies like ICICI Bank, Tata Motors, SBI etc. are already traded in US and someAsian market it is yet to be traded in Indian market. And RBI is looking at CDS for debt issuedin the domestic market. The move by RBI to launch CDS in India is considered significantconsidering its cautious nature and the role CDS played in subprime crisis. The move iswelcomed by some of the banks. ―There is surely a need for such a product (CDS)‖ said AshishVaidya, head of interest rate trading at HDFC Bank. ―Indian regulators have the benefit oflearning from 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 expects to developthe corporate bond market through the introduction of CDS contracts.The CDS market will be an OTC market in India which means the deals between the protectionbuyer and the protection seller will be bilateral deals making them do the negotiation and pricingfor the CDS contracts. In the infancy stage of CDS market in India one can have a tradereporting platform which will be gathering all the information about the trades happening.Thiswill provide the required transparency and help in gaining the confidence in the product. Oncethe market matures one can think of having an electronic order matching platform with centralcounterparty settlement (like CCIL).The Clearing Corporation of India (CCIL) was set up with the prime objective to improveefficiency in the transaction settlement process, insulate the financial system from shocksemanating from operations related issues, and to undertake other related activities that wouldhelp to broaden and deepen the Money, Gilts and Forex markets in India. The roleof CCIL isunique as it provides settlement of three different products under oneumbrella. It has beeninstrumental in setting up and running electronic trading platformslike NDS-OM, NDS-Call andNDS-Auction system for the central bank that had helpedthe Indian market to evolve and grow Emergence of Credit Default Swaps in India
  • 115. immensely. It had also immensely bolstered CCILs image in terms of ability to providetransparent, efficient, robust and cost effective end to end solutions to market participants invarious markets. The introduction of ClearCorp14Repo Order Matching System (CROMS), ananonymous Repo trading platform, has also changed the trading pattern in Repo market i.e.shifting of interest from specific security to basket of securities. The success of its money marketproduct CBLO has helped the market participants as well as RBI to find a solution to unusualdependence on uncollateralized call market. The total settlement volume during 2009-10 ingovernment securities, forex market and CBLO stood at Rs.14934 billion, Rs.25424 billion,andRs.20433 billion respectively.The CCIL already has the necessary infrastructure for the settlement of OTC products likeinterest rate swaps and forward rate agreement. CCIL already has a trade reporting platform forIRS which provides non-guaranteed settlement for the reported trades. NowCCIL is movingtowards the guaranteed settlement of IRS which will involve tradematching, initial and MTMmargining, exposure check, novation, multilateral netting,default handling etc. On this backdropone can say CCIL is well equipped with all its experience to act as central counterparty for thesettlement of CDS contracts.But before the introduction of CDS contracts in India, there are some issues that need tobe 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 the 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 acredit event has been removed from North American CDS contracts. So more clear information on restructuring as credit event is required. Emergence of Credit Default Swaps in India
  • 116. 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 in controvertibleAlthough CDS has helped in perforation of subprime crisis which has created negativevibesabout CDS but CDS as in instrument is very effective means of hedging your risk.And in India itis expected to provide the needed push to the corporate bond market. So itwon‘t be long for theCDS market to pick up in India. Emergence of Credit Default Swaps in India
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