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