Final Cds Summer

8/13/2019 Final Cds Summer

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THE MET LEAGUE OF COLLEGES

METCOURSE:

PGDM (e-Business)

SUMMER INTERNSHIP PROJECT REPORT

ON

CREDIT DEFAULT SWAPS

SUBMITTED TO : HDFC BANK (LOWER PAREL)

TREASURY DEPARTMENT

SUBMITTED BY : NISHANT SHAH ( ROLL NO : 104 )

YEAR : 2010 - 2012


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ACKNOWLEDGEMENT

Its a great pleasure to present this report of

summer training in HDFC BANK (LOWER PAREL

MUMBAI) in partial fulfilment of MBA

Programme from MET LEAGUE OF COLLEGES.

At the outset, I would like to express my immense

gratitude to my training guide MR. BHASKAR

PANDA & MR. PRATIK KOTHARIfor guiding me

right from the inception till the successful

completion of the training.

I am falling short of words for expressing my

feelings of gratitude towards him for extending

their valuable guidance and support for critical

reviews of project and the report and above all the

moral support he had provided me with all stages

of this training.


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INDEX

Sr. no PARTICULARS Pg. No.

1. Glossary2. Terminologies used :

Derivatives Credit Derivatives Credit Risk Reference Entity Protection Buyer Protection Seller Naked CDS Reference Entities/Obligations Credit Event Contingent Event Settlement :Physical ,cash , binary settlements Users Market makers Single name credit default swaps Plain Vanilla interest rate swap

3. Derivatives Introduction Origin of Derivatives Derivatives in India Milestones Uses of Derivatives


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Application of Derivatives4. Types of Derivatives

Over the counter Derivatives Exchange Traded Derivatives Forwards & Futures Options Swaps

5. OTC Market Growth6. Factors generally attributed as the major driving forcebehind growth of financial derivatives7. Credit Derivatives

Introduction Types of Credit Derivatives Risks of Credit Derivatives : credit, market, legal

risk

Growth of Credit Derivatives8. Credit Default Swaps

Origin Definition Significance Of CDS CDS Premium CDS Size &Price Trigger Events

9. Types of Credit Default Swaps


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10. Credit Default SwapsNot an Insurance11. Settlements Types12. Subprime Crisis

Background Role

13. International Swaps and Derivative Association(ISDA)14. The Depository Trust and Clearing Corporation (DTCC)15. Central Counterparty settlement16. The Indian Market

Credit Derivatives Market & Benefits Reasons for under developed Bond market New Guidelines for CDS (23rdmay 2011)

17. a)Methodologyb)Chartsc)Findingsd)Conclusion

18. Final conclusionAPPENDIX 1 : QUESTIONNAIRE


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Glossary of Terms

This abbreviated glossary covers only the most commonly encountered

terms.

ABS Asset Backed Securities

ARM Adjustable Rate Mortgage

BBA British Bankers' Association

BIS Bank for International Settlements

CCIL The Clearing Corporation of India Ltd.

CCP Central Counterparty

CDO Collateralized Debt Obligations

CDS Credit Default SwapCDX Credit Derivative Index

CLN Credit Linked Note

CME Chicago Mercantile Exchange

DTCC Depository Trust and Clearing Corporation

ETD Exchange Traded Derivative

ICE Intercontinental Exchange

IMM Inside Market Midpoint

ISDA International Swaps and Derivatives AssociationMBS Mortgage Backed Securities

OCC The Office of the Comptroller of the Currency

OTC Over the counter

RBI Reserve Bank of India

SIV Structured Investment Vehicle

SPV Special Purpose Vehicle

STP Straight through processing

TIW Trade Information WarehouseTRS Total Report Swap


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TERMINOLOGIES USED

The following section gives a brief explanation of the various terms

and entities involved in a CDS transaction.

DERIVATIVES: A derivative is a risk transfer agreement, the value of

which is derived from the value of an underlying asset. The

underlying asset could be an interest rate, a physical commodity, a

companys equity shares, an equity index, a currency, or virtually

any other tradable instrument upon which parties can agree.

Credit derivatives :A credit derivative is a privately negotiatedagreement that explicitly shifts credit risk from one party to the

other

Credit Risk:In common usage credit risk is the risk that the counter-

party will default. It can also be the risk of a credit rating

downgrade or a technical defaultdeterioration in the current ratio

of a project or a violation of bond covenants.

Reference Entity: It is the entity whose risk of default is being

traded. Generally, Reference Assets are underlying debt obligations

like bonds or loans

Protection Buyer: The Party that buys the CDS on a Reference

Entity.

Protection Seller:The Party that sells CDS on a Reference Entity.

Naked CDS: When the Protection Buyer does not own the

Reference Asset, the contract is called a Naked CDS.


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Reference entities/obligations

ABCDS transactions are reference obligation specific. In most

ABCDS, credit events occur with respect to the reference entity (the

issuer of the ABS) and a specific security issued by that reference

entity. With certain exceptions, settlement of the transactions is

affected either by delivery of that specific security or by reference

to the payment performance or market value of that specific

security. The rationale for referencing a specific tranche is that ABS

performance can vary from deal-to-deal, for a variety or reasons.

Vintage. Credit performance can vary depending on the year of

origination. Relaxed underwriting standards in a period of intense

competition, for example, may lead to higher losses in a particular

vintage. Poor economic conditions (e.g., rising rates and higher

unemployment) may also impact a specific origination year more

acutely.

Range of asset quality. Issuers frequently originate and securitize

a broad range of assets, and the underlying borrowers can have

different credit profiles. Sellers of protection seek to isolate credit

risks, and therefore would not allow a default of any issue to qualify

as a credit event.

Senior and subordinate tranches. ABS transactions typically

comprise senior and subordinate bonds. By design, subordinate

tranches absorb losses first (once credit enhancement has eroded),

and are thus more likely to default than more senior tranches.

For these reasons, a protection seller does not want a default onany bond of an issuer to trigger a credit event.

Credit Event:A credit event triggers payment from the Protection

Seller to the Protection Buyer. Consequently, the definition of a

credit event is, arguably, the most important part of a CDS contract.


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Generally, a Credit Event includes bankruptcy (for non-sovereign

entities) or moratorium (for sovereign entities only), repudiation,

material adverse restructuring of debt, obligation acceleration or

obligation default. However, it is the parties to the CDS contract

who, after negotiation, decide the specific definition of the Credit

Event.

There has been an increasing move towards standardisation on the

definition of a Credit Event. In 1999, the International Swaps and

Derivative Association published documentation which set out

standard definitions for all the Credit Events. The adoption of these

definitions reduces legal risk, decreases administrative costs and

increases the tradability of the instrument.

Contingent Payment: The amount that the Protection Seller pays

the Protection Buyer upon occurrence of the Credit Event. The

contract generally lays down the method to calculate the same.

Settlement:Parties to a contract decide on the mode of settlement.

This can be through:

a) Physical Settlement: After the occurrence of the Credit Event,

the Protection Seller pays the contingent fee to the Protection

Buyer. The Protection Buyer physically delivers the bond to the

Protection Seller. Physical settlement implies that the Protection

Buyer owns the Reference Entity.

b) Cash Settlement:Cash payment equal to Par less Recovery rate

of Reference Asset, is made by the Protection Seller to the

Protection Buyer. For eg: If the value of the bond has dropped from

Rs.100 to Rs. 25 after the Credit Event, the Protection Seller shall

pay the Protection Buyer is Rs. 75.


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c) Binary Settlement: The counterparties settle on a pre-

determined sum for the contingent payment.

Users: Entities permitted to buy credit protection (buy CDS

contracts) only to hedge their underlying credit risk on corporate

bonds. Such entities are not permitted to hold credit protection

without having eligible underlying as a hedged item. Users are

also not permitted to sell protection and are not permitted to

hold short positions in the CDS contracts. However, they are

permitted to exit their bought CDS positions by unwinding them

with the original counterparty or by assigning them in favour of

buyer of the underlying bond.

Market-makers:Entities permitted to quote both buy and/or sell

CDS spreads. They would bepermitted to buy protection without

having the underlying bond.

Single-name CDS: These are credit derivatives where thereference entity is a single name .

Multi-name CDS:CDS contracts where the reference entity is more

than one name as in portfolio or basket credit default swaps or

credit default swap indices

Plain Vanilla Interest Rate Swap

The most common and simplest swap is a "plain vanilla" interest

rate swap. In this swap, Party A agrees to pay Party B a

predetermined, fixed rate of interest on a notional principal on

specific dates for a specified period of time. Concurrently, Party B

agrees to make payments based on a floating interest rate to Party
http://www.investopedia.com/terms/f/fixedinterestrate.asphttp://www.investopedia.com/terms/n/notionalprincipalamount.asphttp://www.investopedia.com/terms/f/floatinginterestrate.asphttp://www.investopedia.com/terms/f/floatinginterestrate.asphttp://www.investopedia.com/terms/n/notionalprincipalamount.asphttp://www.investopedia.com/terms/f/fixedinterestrate.asp


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A on that same notional principal on the same specified dates for

the same specified time period. In a plain vanilla swap, the two cash

flows are paid in the same currency. The specified payment dates

are called settlement dates, and the time between are called

settlement periods. Because swaps are customized contracts,

interest payments may be made annually, quarterly, monthly, or at

any other interval determined by the parties

With a basic understanding of the terms in a CDS contract, we now

turn to the actual working of the contract.

Before that lets understand derivatives.
http://www.investopedia.com/terms/s/settlementdate.asphttp://www.investopedia.com/terms/s/settlementdate.asp


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Derivatives

Derivatives have become increasingly important in financial

markets. We have observed exciting developments in the last 25

years: the most successful innovations in capital markets.

By far the most significant event in finance during the past decade

has been the extraordinary development and expansion of financial

derivatives. These instruments enhance the ability to differentiate

risk and allocate it to those investors most able and willing to take it

- a process that has undoubtedly improved national productivity

growth and standards of living-- Alan Greenspan

(former) chairman, Board of Governors of the US Federal Reserve

System.

But again early falls of Baring bank, LTCM (Long-Term Capital

Management), Asian Financial Crisis and the most recent financial

crisis posed a big question mark on the rapid development ofDerivatives.

Even Warren Buffetsaid in Berkshire Hathaway annual report for

2002 that derivatives are financial weapons of mass

destruction, carrying dangers that, while now latent, are

potentially lethal. Now with these conflicting views lets

understand what exactly are derivative and why it posses apotential threats or potential opportunities in financial markets?


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Introduction

Definition of Derivatives

One of the most significant events in the securities markets hasbeen the development and expansion of financial derivatives. The

term derivatives is used to refer to financial instruments which

derive their value from some underlying assets. The underlying

assets could be equities (shares), debt (bonds, T-bills, and notes),

currencies, and even indices of these various assets, such as the

Nifty 50 Index. Derivatives derive their names from their respective

underlying asset. Thus if a derivatives underlying asset is equity, it

is called equity derivative and so on. Derivatives can be traded

either on a regulated exchange, such as the NSE or off the

exchanges, i.e., directly between the different parties, which is

called over-the-counter (OTC) trading. (In India only exchange

traded equity derivatives are permitted under the law.) The

basic purpose of derivatives is to transfer the price risk (inherent in

fluctuations of the asset prices) from one party to another; they

facilitate the allocation of risk to those who are willing to take it. In

so doing, derivatives help mitigate the risk arising from the future

uncertainty of prices. For example, on November 1, 2009 a rice

farmer may wish to sell his harvest at a future date (say January 1,

2010) for a pre-determined fixed price to eliminate the risk of

change in prices by that date. Such a transaction is an example of a

derivatives contract. The price of this derivative is driven by the

spot price of rice which is the "underlying".


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Origin of derivatives

While trading in derivatives products has grown tremendously in

recent times, the earliest evidence of these types of instruments

can be traced back to ancient Greece. Even though derivatives havebeen in existence in some form or the other since ancient times, the

advent of modern day derivatives contracts is attributed to farmers

need to protect themselves against a decline in crop prices due to

various economic and environmental factors. Thus, derivatives

contracts initially developed in commodities. The first futures

contracts can be traced to the Yodoya rice market in Osaka, Japan

around 1650. The farmers were afraid of rice prices falling in thefuture at the time of harvesting. To lock in a price (that is, to sell the

rice at a predetermined fixed price in the future), the farmers

entered into contracts with the buyers.

These were evidently standardized contracts, much like todays

futures contracts. In 1848, the Chicago Board of Trade (CBOT) was

established to facilitate trading of forward contracts on various

commodities. From then on, futures contracts on commodities haveremained more or less in the same form, as we know them today.

While the basics of derivatives are the same for all assets such as

equities, bonds, currencies, and commodities, we will focus on

derivatives in the equity markets

Derivatives in India

In India, derivatives markets have been functioning since the

nineteenth century, with organized trading in cotton through the

establishment of the Cotton Trade Association in 1875. Derivatives,

as exchange traded financial instruments were introduced in India


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in June 2000. The National Stock Exchange (NSE) is the largest

exchange in India in derivatives, trading in various derivatives

contracts. The first contract to be launched on NSE was the Nifty 50

index futures contract. In a span of one and a half years after the

introduction of index futures, index options, stock options and stock

futures were also introduced in the derivatives segment for trading.

NSEs equity derivatives segment is called the Futures & Options

Segment or F&O Segment. NSE also trades in Currency and Interest

Rate Futures contracts under a separate segment. A series of

reforms in the financial markets paved way for the development of

exchange-traded equity derivatives markets in India. In 1993, the

NSE was established as an electronic, national exchange and it

started operations in 1994. It improved the efficiency and

transparency of the stock markets by offering a fully automated

screen-based trading system with real-time price dissemination. A

report on exchange traded derivatives, by the L.C. Gupta

Committee, set up by the Securities and Exchange Board of India

(SEBI), recommended a phased introduction of derivatives

instruments with bi-level regulation (i.e., self-regulation by

exchanges, with SEBI providing the overall regulatory and

supervisory role). Another report, by the J.R. Varma Committee in

1998, worked out the various operational details such as margining

and risk

management systems for these instruments. In 1999, the Securities

Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that

derivatives could be declared as securities. This allowed theregulatory framework for trading securities, to be extended to

derivatives. The Act considers derivatives on equities to be legal and

valid, but only if they are traded on exchanges. The Securities

Contracts (Regulation) Act, 1956 defines "derivatives" to include:


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1. A security derived from a debt instrument, share, loan whether

secured or unsecured, risk instrument, or contract for differences or

any other form of security.

2. A contract which derives its value from the prices, or index of

prices, of underlying securities.

At present, the equity derivatives market is the most active

derivatives market in India. Trading volumes in equity derivatives

are, on an average, more than three and a half times the trading

volumes in the cash equity markets.

Table : Milestones in the development of Indian derivative marketNovember18, 1996 L.C. Gupta Committee set up to draft a policy framework for

introducing derivatives

May 11, 1998 L.C. Gupta committee submits its report on the policy

Framework

May 25, 2000 SEBI allows exchanges to trade in index futures

June 12, 2000 Trading on Nifty futures commences on the NSE

June 4, 2001 Trading for Nifty options commences on the NSE

July 2, 2001 Trading on Stock options commences on the NSE

November 9, 2001 Trading on Stock futures commences on the NSE

August 29, 2008 Currency derivatives trading commences on the NSE

August 31, 2009 Interest rate derivatives trading commences on the NSE

February 2010 Launch of Currency Futures on additional currency pairs

October 28, 2010 Introduction of European style Stock Options

October 29, 2010 Introduction of Currency Options

May 23,2011 Guidelines for Credit Default Swaps by RBI

October 24,2011 Launch of Credit Default Swap in India for first time


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Two important terms

Before discussing derivatives, it would be useful to be familiar with

two terminologies relating to the underlying markets. These are as

follows:

1.4.1 Spot Market

In the context of securities, the spot market or cash market is a

securities market in which securities are sold for cash and delivered

immediately. The delivery happens after the settlement period. Let

us describe this in the context of India. The NSEs cash market

segment is known as the Capital Market (CM) Segment. In this

market, shares of SBI, Reliance, Infosys, ICICI Bank, and other public

listed companies are traded. The settlement period in this market is

on a T+2 basis i.e., the buyer of the shares receives the shares two

working days after trade date and the seller of the shares receives

the money two working days after the trade date.

Index

Stock prices fluctuate continuously during any given period. Prices

of some stocks might move up while that of others may move

down. In such a situation, what can we say about the stock market

as a whole? Has the market moved up or has it moved down during

a given period?

Similarly, have stocks of a particular sector moved up or down? To

identify the general trend in the market (or any given sector of themarket such as banking), it is important to have a reference

barometer which can be monitored. Market participants use

various indices for this purpose. An index is a basket of identified

stocks, and its value is computed by taking the weighted average of

the prices of the constituent stocks of the index. A market index for


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example consists of a group of top stocks traded in the market and

its value changes as the prices of its constituent stocks change. In

India, Nifty Index is the most popular stock index and it is based on

the top 50 stocks traded in the market. Just as derivatives on stocks

are called stock derivatives, derivatives on indices such as Nifty are

called index derivatives.

Uses of Derivatives

1 Risk management

The most important purpose of the derivatives market is risk

management. Risk management for an investor comprises of the

following three processes:

Identifying the desired level of risk that the investor is willingto take on his investments

Identifying and measuring the actual level of risk that theinvestor is carrying

Making arrangements which may include trading(buying/selling) of derivatives contractsthat allow him to

match the actual and desired levels of risk.

2 Market efficiency

Efficient markets are fair and competitive and do not allow an

investor to make risk free profits. Derivatives assist in improving the

efficiency of the markets, by providing a self-correcting mechanism.

Arbitrageurs are one section of market participants who trade

whenever there is an opportunity to make risk free profits till theopportunity ceases to exist. Risk free profits are not easy to make in

more efficient markets. When trading occurs, there is a possibility

that some amount of mispricing might occur in the markets. The

arbitrageurs step in to take advantage of this mispricing by buying

from the cheaper market and selling in the higher market. Their


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actions quickly narrow the prices and thereby reducing the

inefficiencies.

3 Price discovery

One of the primary functions of derivatives markets is pricediscovery. They provide valuable information about the prices and

expected price fluctuations of the underlying assets in two ways:

1.many of these assets are traded in markets in differentgeographical locations.

Because of this, assets may be traded at different prices in different

markets. In derivatives markets, the price of the contract often

serves as a proxy for the price of the underlying asset. For example,

gold may trade at different prices in Mumbai and Delhi but a

derivatives contract on gold would have one value and so traders in

Mumbai and Delhi can validate the prices of spot markets in their

respective location to see if it is cheap or expensive and trade

accordingly.

2.the prices of the futures contracts serve as prices that can beused to get a sense of the market expectation of future prices.

example, say there is a company that produces sugar and expects

that the production of sugar will take two months from today. As

sugar prices fluctuate daily, the company does not know if after two

months the price of sugar will be higher or lower than it is today.How does it predict where the price of sugar will be in future? It can

do this by monitoring prices of derivatives contract on sugar (say a

Sugar Forward contract). If the forward price of sugar is trading

higher than the spot price that means that the market is expecting

the sugar spot price to go up in future. If there were no derivatives


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price, it would have to wait for two months before knowing the

market price of sugar on that day. Based on derivatives price the

management of the sugar company can make strategic and tactical

decisions of how much sugar to produce and when.

Applicants of Derivatives:

Derivative contracts provide an easy and straightforward way to

both reduce risk -hedging, and to bear extra risk -speculating.

Hedging: Derivatives can be used to mitigate the risk of economic

loss arising from changes in the value of the underlying. This activity

is known as hedging. For example, a wheat farmer and a millercould sign a futures contract to exchange a specified amount of

cash for a specified amount of wheat in the future. Both parties

have reduced a future risk: for the wheat farmer, the uncertainty of

the price, and for the miller, the availability of wheat.

Speculation: Derivatives can be used by investors to increase the

profit arising if the value of the underlying moves in the direction

they expect. This activity is known as speculation. Speculators will

want to be able to buy an asset in the future at a low price

according to a derivative contract when the future market price is

high, or to sell an asset in the future at a high price according to a

derivative contract when the future market price is low.

Arbitrage: Individuals and institutions may also look for arbitrage

opportunities, as when the current buying price of an asset falls

below the price specified in a futures contract to sell the asset.


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Types of Derivatives:

Broadly speaking there are two distinct groups of derivative

contracts, which are distinguished by the way they are traded in

market:

Over-the-counter (OTC) derivatives: OTC derivatives are contracts

that are traded (and privately negotiated) directly between two

parties, without going through an exchange or other intermediary.

Products such as swaps, forward rate agreements, and exotic

options are almost always traded in this way. The OTC derivatives

market is huge. According to the Bank for International Settlements,

the total outstanding notional amount is USD 592 trillion (as ofDecember 2008). Because OTC derivatives are not traded on an

exchange, they are subject to counter party risk as each counter

party relies on the other to perform.

Exchange-traded derivatives (ETD): ETDs are those derivatives

products that are traded via specialized derivatives exchanges or

other exchanges. A derivatives exchange acts as an intermediary toall related transactions, and takes Initial margin from both sides of

the trade to act as a guarantee. The world's largest derivatives

exchanges (by number of transactions) are the Korea Exchange

(which lists KOSPI Index Futures & Options), Eurex (which lists a

wide range of European products such as interest rate & index

products), and CME Group (made up of the 2007 merger of the

Chicago Mercantile Exchange and the Chicago Board of Trade(CBOT) and the 2008 acquisition of the New York Mercantile

Exchange). According to BIS, the combined turnover in the world's

derivatives exchanges totaled USD 401 trillion during Q1 2011.Some

types of derivative instruments also may trade on traditional

exchanges.


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Common Derivative Contract Types:

Some of the most basic forms of Derivatives are Futures, Forwards,

Options and Swaps.

Forward and Future: Forward contracts are agreements by two

parties to engage in a financial transaction at a future point in time.

A forward contract is traded in the OTC market. Future contracts

are similar to forward contract but they normally are traded on an

exchange and are standardized. To make sure that the

clearinghouse is financially sound and does not run into financial

difficulties that might jeopardize its contracts, buyers or sellers of

futures contracts must put an initial deposit, called a margin

requirement. Futures contracts are then marked to market every

day. What this means is that at the end of every trading day, the

change in the value of the futures contract is added to or subtracted

from the margin account. A final advantage that futures markets

have over forward markets is that most futures contracts do not

result in delivery of the underlying asset on the expiration date,

whereas forward contracts do.

Options: An option is a contract between a buyer and a seller that

gives the buyer the right, but not the obligation, to buy or to sell a

particular asset (the underlying asset) at a later day at an agreed

price. In return for granting the option, the seller collects a payment

(the premium) from the buyer. A call option gives the buyer the

right to buy the underlying asset; a put option gives the buyer of the

option the right to sell the underlying asset. If the buyer chooses toexercise this right, the seller is obliged to sell or buy the asset at the

agreed price. The buyer may choose not to exercise the right and let

it expire. There are two types of option contracts: American options

can be exercised at any time up to the expiration date of the


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contract, and European options can be exercised only on the

expiration date.

Swaps: Swaps are financial contracts that obligate each party to

the contract to exchange (swap) a set of payments (not assets) it

owns for another set of payments owned by another party. There

are two basic kinds of swaps. Currency swaps involve the exchange

of a set of payments in one currency for a set of payments in

another currency. Interest-rate swaps involve the exchange of one

set of interest payments for another set of interest payments, all

denominated in the same currency. Most swaps are traded OTC,

tailor-made for the counterparties.

Risks with Financial Derivatives:

The use of derivatives can result in large losses due to the use of

leverage, or borrowing.

Derivatives (especially swaps) expose investors to counter-party risk.

Derivatives control an increasingly larger notional amount ofassets and this may lead to distortions in the real capital and

equities markets.

Derivatives massively leverage the debt in an economy,making it ever more difficult for the underlying real economy

to service its debt obligations and curtailing real economic

activity, which can cause a recession or even depression.

New innovations on financial derivatives are too complicatedthat even some financial managers are not sophisticated

enough to use them.


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OTC Derivatives growth:

Derivatives market was already a very big in 1998, but it has

exploded since then. The amounts outstanding of OTC derivatives

since 1998 are broken down into their various types as shown

below.

As can be seen from above figure the total OTC derivative market

was almost $600 trillion. Thus, in 10 years it has gown 826%. Some

of the subcategories have grown even more than simple average (of

826%) like, commodity contracts increased over 2000%, interestrate contracts (which make up the largest portion, 66% of OTC

market) increased over 900% in last 10 years and CDS (Credit

Default Swap) contracts increased over 905% in just three and half

years (more about CDS is explained later).


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Factors generally attributed as the major driving force behind

growth of financial derivatives are:

1. Increased Volatility in asset prices in financial markets

2. Increased integration of national financial markets with the

international markets

3. Marked improvement in communication facilities and sharp

decline in their costs

4. Development of more sophisticated risk management tools,

providing economic agents a wider choice of risk management

strategies, and

5. Innovations in the derivatives markets, which optimally combine

the risks and returns over a large number of financial assets, leading

to higher returns, reduced risk as well as transaction costs as

compared to individual financial assets.

Although there are risks associated with derivatives there are

number of advantages too. So derivatives can be considered as

necessary evils.

The world seems to be dividend into two camps:

those who embrace financial derivatives as the Holy Grail ofthe new investment area, and

those who denigrate derivatives as the financial Antichrist.-David Edington

But still many believes derivatives are just a bet on a bet. Around

2002, soon after the effects of the dotcom collapse ebbed away and

Alan Greenspan flooded the world with cheap credit, another form

of betting became possible. This was the credit derivative. These


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credit derivatives played a vital role in growing the subprime crisis

all the more and still continuing to do the same with CDS being a

frontrunner along with TRS, credit options, CLN, etc. So it is

important to understand about credit derivatives which are dealt

later

Credit Derivatives

The development of credit derivatives is a logical extension of the

ever-growing array of derivatives trading in the market. The

concept of a derivative is to create a contract that transfers somerisk or some volatility. Credit derivatives apply the same notion to a

credit asset. Credit asset is the asset that a provider of credit

creates, such as a loan given by a bank, or a bond held by a capital

market participant. A credit derivative enables the stripping of the

loan or the bond, from the risk of default, such that the loan or the

bond can continue to be held by the originator or holder thereof,

but the risk gets transferred to the counterparty. The counterpartybuys the risk obviously for a premium, and the premium represents

the rewards of the counterparty. Thus, credit derivatives essentially

use the derivatives format to acquire or shift risks and rewards in

credit assets, viz., loans or bonds, to other financial market

participants.

A definition of Credit Derivative:

Credit derivatives can be defined as arrangements that allow one

party (protection buyer or originator) to transfer, for a premium,

the defined credit risk, or all the credit risk, computed with

reference to a notional value, of a reference asset or assets, which it


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may or may not own, to one or more other parties (the protection

sellers).

So here the protection buyer continues to hold the reference asset

(loan or bond) and protection seller holds the risk associated with

the asset (loan or bond) also called as holding synthetic asset. The

protection seller holds the risk of default, losses, foreclosure,

delinquency, prepayment, etc. and the reward of premium.

There could be two possible ways of settlement in case of credit

event. In first case, physical settlement, protection seller gives the

par value of asset to the protection buyer and protection buyer

hands over the asset to the protection seller. Whereas in second

case, cash settlement the difference between the par value of the

asset and the market value of the asset is given by protection seller

to the protection buyer.

Types of Credit Derivatives:

Some of the fundamental types of credit derivatives are creditdefault swap, total return swap, credit linked notes, and credit

spread options.

Credit Default Swaps: A credit default swap (CDS) is a credit

derivative contract between two counterparties. The buyer makes

periodic payments to the seller, and in return receives a payoff if an

underlying financial instrument defaults. Credit default swaps are

the most important type of credit derivatives in use in the market.

Credit default swaps are explained in detail in next chapter.


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Total Return Swaps: As the name implies, a total return swap is a

swap of the total return out of a credit asset swapped against a

contracted prefixed return. The total return out of a credit asset is

reflected by the actual stream of cash-flows from the reference

asset as also the actual appreciation/depreciation in its price over

time, and can be affected by various factors, some of which may be

quite extraneous to the asset in question, such as interest rate

movements. Nevertheless, the protection seller here guarantees a

prefixed spread to the protection buyer, who in turn, agrees to pass

on the actual collections and actual variations in prices on the credit

asset to the protection seller. Total Return Swap is also known as

Total Rate of Return Swap (TRORS).

Credit Linked Notes: It is a security with an embedded credit

default swap allowing the issuer (protection buyer) to transfer a

specific credit risk to credit investors. CLNs are created through a

Special Purpose Vehicle (SPV), or trust, which is collateralized with

securities. Investors buy securities from a trust that pays a fixed or

floating coupon during the life of the note. At maturity, the

investors receive par unless the referenced credit defaults or

declares bankruptcy, in which case they receive an amount equal to

the recovery rate. The trust enters into a default swap with a deal

arranger. In case of default, the trust pays the dealer par minus the

recovery rate in exchange for an annual fee which is passed on to

the investors in the form of a higher yield on the notes.

Credit Spread Options: A financial derivative contract that

transfers credit risk from one party to another. A premium

is paid by the buyer in exchange for potential cash flows if a

given credit spread changes from its current level. The buyer of


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credit spread put option hopes that credit spread will

widen and credit spread call buyer hopes for narrowing of

credit spread. It can be viewed as similar to that of credit

default swaps but it hedges also against credit

deterioration along with default. Consider the buyer of credit

spread put: he/she pays a premium for the put. If the bond

(the reference entity) deteriorates, the spread on the bond

will increase and the buyer will profit. But if the bond

quality increases, the credit spread will narrow, bond price

will decrease, and the put will be worthless (i.e., put buyer has lost

the premium). In summary, the credit spread put buyer wants to

hedge against price deterioration and/or default risk of the

obligation.

The payoff is

duration (D) x notional (N) x [credit spread minus (-) the strike

spread; CS - K].


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Risks of Credit Derivatives:

Various risks associated with credit derivatives are credit risk, market

risk, and legal risk.

Credit Risk: The protection seller is having a credit riskrelated to underlying reference asset because protection seller

synthetically holds the asset and needs to do due diligence to

counter this risk. Another risk is associated is

counterparty risk against protection seller if he fails to make

good of his obligations.

Market Risk: Market risk is associated with credit derivatives tradersas the prices of the instruments are a function of interest rates, the

shape of the yield curve, and credit spread. Other types of risks

involved are marking to market risk, margin call risks, etc.

Legal Risk:Lack of standard documentation and agreement as to the

definitions of credit event leads to legal risks. Usage of master

agreements though has simplified and homogenized the

trading of credit derivatives. More efforts are being taken

recently to counter this risk with International Swaps and

Derivatives Association (ISDA) taking active role in it. The most

important legal issues still revolves around the nature of credit

event and the nature of obligations.

Growth of Credit Derivatives:

Within no time credit derivatives have grown to a great

extent to be a big part of derivatives segment after

interest rate contracts (89% Q410) and foreign exchange

contracts (14.2% Q410) as per notional amounts outstanding


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(Credit derivatives 9.2% Q310, Securitization, index products

and structured credit trading.

Much of the significance credit derivatives enjoy today is because of

the marketability imparted by securitization. A securitized credit

derivative, or synthetic securitization, is a device of embedding acredit derivative feature into a capital market security so as to

transfer the credit risk into the capital markets. The synthesis of

credit derivatives with securitization methodology has

complimented each other. This had allowed keeping the

portfolio of assets on the books but transferring the credit risk

associated with it.

The index products have also contributed to the

increasing popularity of credit derivatives. It provides a means

to buy or sell exposure to a broad-based indices, or sub- indices

diversifying the risks instead to buying or selling exposure to

the credit risk of a single entity

The third important factor contributing to the growth of

credit derivatives is structured credit trading or tranching.Here the portfolio of assets is divided into various subclasses

known as tranches (means slice in French) to fulfill the risk appetite

of various investors. The tranches are divided into various

levels like senior tranche, mezzanine tranche, subordinate

tranche, and equity tranche with the risk of default rising in

a sequence for these tranches

Talking about the growth of credit derivatives from year-

end 2003 to 2010, credit derivative contracts grew at a

100% compounded annual growth rate. But due to the

global turmoil the growth has been curtailed from the end of 2007


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The composition of credit derivatives is shown in the

figure. As can be seen credit default swaps dominates the

composition of creditderivatives followed by total return swaps.

The composition of credit default swaps sometimes makes

people believe that credit derivatives are nothing butcredit default swaps.


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Credit Default Swaps

Origin of CDS:

By the mid-'90s, JPMorgan's books were loaded with

billions of dollars in loans to corporations and foreign

governments, and by federal law it had to keep huge amounts of

capital in reserve in case any of them went bad. But what

if JPMorgan could create a device that would protect it if

those loans defaulted, and free up that capital? And the

solution they come up with is nothing but the origin of Credit

Default Swap.

Credit Default Swap (CDS) is some sort of insurance

policy where the third party assumes the risk of debt going

sour and in exchange will receive regular payments from the bank

who issues debt, similar to insurance premiums. Although the idea

was floating for a while JP Morgan was the first bank to make a bet

on CDS. They opened up a Swap desk in mid-90s and formally

brought the idea of CDS into reality.

Definition:

A CDS is a contract whose buyer makes regular payments to the

seller and in return gets a lump sum in the event that the issuer

defaults on an underlying instrument (typically a bond or a loan)

or is subject to restructure. A CDS contract typically consists of

three elements:


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the reference, which is the underlying credit instrument thatis to be insured by means of a CDS contract;

the buyer who wishes to protect against the risk of thereference being unable to repay the loan;

the seller who, in the event of default on the reference,must pay the principal to the buyer.

A CDS is thus comparable to an insurance because the buyer pays

a premium and receives a lump sum if a certain event occurs.


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Significance of Credit Default Swaps:

CDS creates Liquidity: The CDS adds depth to the

secondary market of underlying credit instruments which may

not be liquid for many reasons.

Risk Management: Credit derivatives makes risk

management more efficient and flexible by allocation of credit

risk to most efficient manager of that risk.

Risk Separation:Credit derivatives allows for separation

of credit risk from other risks of the asset.

Reliable funding source: Credit derivatives help exploit a

funding advantage oravoiding a funding disadvantage.

Since there is no up-front principal outlay required for

most Protection Sellers when assuming a Credit Swap

position, these provide an opportunity to take on credit

exposure in off balance-sheet positions that do not need to

be funded. On the other hand, institutions with low

funding costs may capitalize on this advantage by funding

assets on the balance sheet and purchasing default

protection on those assets. The premium for buying default

protection on such assets may be less than the net spread

such a bank would earn over its funding costs.

CDS Premium: Premium prices - also known as fees or creditdefault spreads - are quoted in basis point per annum of the

contracts notional value. In case of highly distressed credits in

which CDS market remains open upfront premium payment is a

common thing. The CDS spread is inversely related to the credit

worthiness of the underlying reference entity.


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CDS Size & Price:

There are no predetermined limits on the size or maturity of CDS

contracts, which have ranged in size from a few million to several

billions of dollars. In general the contracts are concentrated in the

$10 million to $20 million range with maturities of between one

and 10 years, although 5 years maturities are the most common.

Inevitably, the maturity of a CDS will depend on the credit quality of

the reference entity, with longer-dated contracts of five years and

more only written on the best-rated names. Although there are

differences in the quotes given by banks on CDS prices due to

some

technical reasons rather than financial reasons, but the CDS

premium price more or less remains the same. Over and above a

valuation of credit risk, probability of default, actual loss incurred,

and recovery rate, the various factors in determination of CDS

premium are - liquidity, regulatory capital requirements, market

sentiments and perceived volatility, etc.

Trigger Events:

The market participants view the following three to be the

most important trigger events:

Bankruptcy Failure to Pay Restructuring Obligation acceleration or obligation default Repudiation / Moratorium


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Bankruptcy, the clearest concept of all, is the reference entitys

insolvency or inability to repay its debt. Failure-to-Pay occurs

when the reference entity, after a certain grace period,

fails to make payment of principal or interest.Restructuring refers to a change in the terms of debt

obligations that are adverse to the creditors.

Types of Credit Default Swaps:

The CDSs can be classified as Single-name CDSs or Multi-name

CDSs.

Single-name CDS

The simplest - and most common - type of credit default swap is

one where there is just onereference entity.This is called a single

name credit default swap. The reference entity can be any

borrower, but is most often one of a few hundred widely traded

companies (corporate or financials)or a handful of governments

(soverigns). Credit default swaps can be used to transfer types of

credit risk other than borrowings (such as trade debt), but these

contracts are not standard and are rarely seen in practice.

A single name credit default swap acts like an insurance contract

against the default of a reference entity. The buyer of protection

(known in the contract as the 'fixed rate payer') makes periodic

premium payments to the seller of protection (the 'floating rate

payer').
http://www.creditflux.com/Glossary/Credit-default-swap-CDShttp://www.creditflux.com/Glossary/Reference-entityhttp://www.creditflux.com/Glossary/Credit-default-swap-CDShttp://www.creditflux.com/Glossary/Reference-entityhttp://www.creditflux.com/Glossary/Corporatehttp://www.creditflux.com/Glossary/Financialhttp://www.creditflux.com/Glossary/Defaulthttp://www.creditflux.com/Glossary/Credit-riskhttp://www.creditflux.com/Glossary/Defaulthttp://www.creditflux.com/Glossary/Payerhttp://www.creditflux.com/Glossary/Payerhttp://www.creditflux.com/Glossary/Defaulthttp://www.creditflux.com/Glossary/Credit-riskhttp://www.creditflux.com/Glossary/Defaulthttp://www.creditflux.com/Glossary/Financialhttp://www.creditflux.com/Glossary/Corporatehttp://www.creditflux.com/Glossary/Reference-entityhttp://www.creditflux.com/Glossary/Credit-default-swap-CDShttp://www.creditflux.com/Glossary/Reference-entityhttp://www.creditflux.com/Glossary/Credit-default-swap-CDS


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Multi-name CDS:

CDS contracts where the reference entity is more than one

name as in portfolio or basket credit default swaps or

credit default swap indices. A basket credit default swap is

a CDS where the credit event is the default of some

combination of the credits in a specified basket of credits.

In the particular case of an nth-to-default basket it is the

nth credit in the basket of reference credits whose default

triggers payments. Another common form of multi-name

CDS is that of the tranched credit default swap.

Variations operate under specifically tailored loss limits -

these may include a first loss tranched CDS,

amezzanine tranched CDS, and a senior (also known as a

supersenior) tranched CDS.

CDS is not insurance:

In many terms CDS is like an insurance policy where thereis a regular premium to be paid, there is a reference

entity and in case of default a pay-off will be paid. But

CDS differs in many aspects from insurance like -

The seller need not be a regulated entity The seller is not required to maintain any reserves

to pay off buyers, although major CDS dealers are

subject to bank capital requirements (because CDS dealers

are generally banks).

Insurers manage risk primarily by setting loss reservesbased on the Law of large numbers, while dealers in CDS


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manage risk primarily by means of offsetting CDS (hedging)

with other dealers and transactions in underlying bond

markets.

In the United States CDS contracts are generallysubject to mark to market accounting, introducingincome statement and balance sheet volatility that

would not be present in an insurance contract.

The buyer of a CDS does not need to own the underlyingsecurity or other form of credit exposure; in fact the

buyer does not even have to suffer a loss from the

default event. By contrast, to purchase insurance the insured

is generally expected to have an insurable interest such as

owning a debt.

Uses of Credit Default Swaps:

As mentioned already CDSs can be used for speculation,

hedging or arbitrage. Out of which we will be consideringhedging and speculation in detail.

CDSs for Hedging:

When JP Morgan invented the credit instrument named

CDS they meant it to be for hedging there credit risk. Although

market has changed a lot since then but still the use of CDSs for

hedging purpose remains to be a primary reason.

Credit default swaps are often used to manage the credit

risk (i.e. the risk of default) which arises from holding debt.

Typically, the holder of, for example, a corporate bond may hedge

their exposure by entering into a CDS contract as the buyer of


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protection. If the bond goes into default, the proceeds from the

CDS contract will cancel out the losses on the underlying bond.

For example, if you own a bond of Apple worth $10 million

maturing after 5 years and you are worried about its

future then you can create a CDS contract with aninsurance company like AIG which will charge a premium of say

200bps annually for insuring your bond. In this way you are

hedging the risk of losing $10 million in case Apple goes

bankrupt. Here you will be paying $200000 to AIG for insuring your

bond. If Apple goes bankrupt you will receive the par value of

bond from AIG and even if does not, you will

lose premium value at the most which is worth transferring the riskto AIG.

Counterparty Risks:

When entering into a CDS, both the buyer and seller of

credit protection take on counterparty risk. Examples of

counter party risks:

The buyer takes the risk that the seller will default. If

reference entity and seller default simultaneously

("double default"), the buyer loses its protection against

default by the reference entity. If seller defaults but

reference entity does not, the buyer might need to replace

the defaulted CDS at a higher cost.

The seller takes the risk that the buyer will default on the

contract, depriving the seller of the expected revenue stream.

More important, a seller normally limits its risk by buying

offsetting protection from another party - that is, it

hedges its exposure. If the original buyer drops out, the


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seller squares its position by either unwinding the hedge

transaction or by selling a new CDS to a third party.

Depending on market conditions, that may be at a lower

price than the original CDS and may therefore involve a

loss to the seller.

As is true with other forms of over-the-counter derivative,

CDS might involve liquidity risk. If one or both parties to a

CDS contract must post collateral (which is common),

there can be margin calls requiring the posting of

additional collateral. The required collateral is agreed on

by the parties when the CDS is first issued. This margin

amount may vary over the life of the CDS contract, if themarket price of the CDS contracts changes, or the credit

rating of one of the partys changes.

CDSs for Speculation:

Credit default swaps allow investors to speculate on changes in

CDS spreads of single names or of market indexes such as the

North American CDX index3 or the European iTraxx index

4. An

investor might speculate on an entity's credit quality, since

generally CDS spreads will increase as credit-worthiness declines

and decline as credit-worthiness increases. The investor might

therefore buy CDS protection on a company in order to speculate

that the company is about to default. Alternatively, the investor

might sell protection if they think that the company'screditworthiness might improve. As there is no need to own an

underlying entity to enter into a CDS contract it can be viewed

as a betting or gambling tool.

For example if you feel that Microsoft is not performing well and

may go bankrupt in near future then you might enter into a CDS


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contract with AIG for a notional value of $10 million for 5 years

even if you dont own a single share of Microsoft. This kind of CDS

is known as Naked CDS.

Subprime CrisisBackground of Subprime Crisis:

The immediate cause or trigger of the crisis was the bursting of the

United States housing bubble which peaked in approximately

2005-2006. High default rates on "subprime" and adjustable

rate mortgages (ARM) began to increase quickly

thereafter. An increase in loan incentives such as easy

initial terms and a long-term trend of rising housing prices

had encouraged borrowers to assume difficult mortgages in the

belief they would be able to quickly refinance at more

favourable terms. However, once interest rates began to

rise and housing prices started to drop moderately in

2006-2007 in many parts of the U.S., refinancing became

more difficult. Defaults and foreclosure activity

increased dramatically as easy initial terms expired, home prices

failed to go up as anticipated, and ARM interest rates reset higher.

Foreclosures accelerated in the United States in late 2006 and

triggered a global financial crisis through 2007 and 2008. In the

years leading up to the crisis, high consumption and low

savings rates in the U.S. contributed to significantamounts of foreign money flowing into the U.S. from

fast-growing economies in Asia and oil-producing

countries. This inflow of funds combined with low U.S.

interest rates from 2002-2004 resulted in easy credit

conditions, which fueled both housing and credit bubbles.


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Loans of various types (e.g., mortgage, credit

card, and auto) were easy to obtain and consumers

assumed an unprecedented debt load. As part of the

housing and credit booms, the amount of financial

agreements called mortgage-backed securities (MBS),

which derive their value from mortgage payments and

housing prices, greatly increased. Such financial innovation

enabled institutions and investors around the world to

invest in the U.S. housing market. As housing prices

declined, major global financial institutions that had

borrowed and invested heavily in subprime MBS reported

significant losses. Defaults and losses on other loan types

also increased significantly as the crisis expanded from

the housing market to other parts of the economy. Total

losses are estimated in the trillions of U.S. dollars globally.

While the housing and credit bubbles built, a series of

factors caused the financial system to become increasingly

fragile. Policymakers did not recognize the increasingly

important role played by financial institutions such asinvestment banks and hedge funds, also known as the

shadow banking system. Some experts believe these

institutions had become as important as commercial

(depository) banks in providing credit to the U.S.

economy, but they were not subject to the same

regulations. These institutions as well as certain regulated

banks had also assumed significant debt burdens while

providing the loans described above and did not have a

financial cushion sufficient to absorb large loan defaults or

MBS losses. These losses impacted the ability of financial

institutions to lend, slowing economic activity. Concerns

regarding the stability of key financial institutions drove


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central banks to take action to provide funds to encourage

lending and to restore faith in the commercial paper

markets, which are integral to funding business operations.

Governments also bailed out key financial institutions,

assuming significant additional financial commitments.

The risks to the broader economy created by the

housing market downturn and subsequent financial

market crisis were primary factors in several decisions by

central banks around the world to cut interest rates and

governments to implement economic stimulus packages.

Effects on global stock markets due to the crisis have been

dramatic. Between 1 January and 11

October 2008, owners of stocks in U.S. corporations had

suffered about $8 trillion in losses, as their holdings

declined in value from $20 trillion to $12 trillion. Losses

in other countries have averaged about 40%. Losses in

the stock markets and housing value declines place

further downward pressure on consumer spending, a key

economic engine. Leaders of the larger developed and

emerging nations met in November 2008 and March 2009

to formulate strategies for addressing the crisis. As of April

2009, many of the root causes of the crisis had yet to

addressed. A variety of solutions have been proposed by

government officials, central bankers, economists, and

business executives.

Now after a brief idea about subprime crisis lets

understand in detail about subprime crisis which shook the

whole world.


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Role of CDS in Subprime Crisis

We already learned about the basics of Credit Default

Swaps. Lets now understand the role played by CDSs in the

subprime crisis.

We learnt about the securitization process in which the

collateral of borrowings was pooled and tranches at different

levels were created. The subprime crisis is the unravelling of a

stupendously leveraged speculative bubble on real estate that built

itself up for about seven years from the beginning of this decade


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International Swaps and Derivatives Association (ISDA):

ISDA, which represents participants in the privately negotiated

derivatives industry, is the largest global financial trade

association, by number of member firms. ISDA Master Agreements

are ingrained into the fabric of the derivatives market worldwide.

According to its mission statement, ISDAs primary purpose is

to encourage the prudent and efficient development of the

privately negotiated derivatives business by:

Promoting practices conducive to the efficient conduct ofthe business, including the development and maintenanceof derivatives documentation

Promoting the development of sound risk managementpractices

Fostering high standards of commercial conduct Advancinginternational public understanding of the business

Educating members and others on legislative regulatory,legal, documentation, accounting, tax, operational,

technological and other issues affecting them and Creating a forum for the analysis and discussion of, and

representing the common interest of its members on, these

issues and developments.

Adherence to ISDA policies is voluntary among the contracting

parties; however, there is an understanding among the financialmarkets that ISDA continuously stays on top of all derivative

issues and attempts to incorporate these issues into policy

and advice for structuring agreements. Hence, most derivative

deals utilize ISDA Master Agreements and Definitions.


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Role of DTCC in CDS:

DTCC provides much wider role than just acting as a datasource by providing services like Trade Information

Warehouse (TIW), Matching and Confirmation service,Novation Consent, etc.

The Trade Information Warehouse (a service offering ofDTCC Deriv/SERV LLC, a wholly-owned subsidiary of

DTCC) is the markets first and only comprehensive trade

database and centralized electronic infrastructure for post-

trade processing of OTC derivatives contracts over their

multi-year lifecycles, from confirmation to paymentcalculation and netting to final settlement.

TIW reports provide weekly information regarding creditderivative products, transaction types (single-name,

index/index tranches), etc.

TIW reports can be accessed at -http://www.dtcc.com/products/derivserv/data/index.php

Apart from these there are many other data sources like Credit

Derivatives Research LLC, Bloomberg, Markit, etc. The credit

rating agencies like Fitch Ratings, Standard & Poors, and Moodys

also provide data on CDSs.

Central Counterparty Settlement :

We understood the concept of central counterparty (CCP) while

understanding the role of CDS in subprime crisis. A CDS is a


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bilateral contract. If you sell protection to counterparty, and

buy protection from counterparty then economically you may

be hedged but you are exposed to two legs of counterparty

risks which brings difference between the gross and net notional

values as shown below

One way of addressing this risk in chains of trades is a service

called TriOptima13, which takes trades from multiple

counterparties simultaneously and reduces chains to their end

counterparties and eliminates the circle completely. As shown

above the trade between A

through E gets reduced to trade between A & E, of course by

the consent of all the parties. During 2008, TriOptima

eliminated USD30.2tn of CDS notional trades

A more comprehensive solution would be to establish a central

counterparty such that both protection buyer and seller would be

dealing only with CCP acting as counterparty (as illustrated in the

figure). The benefit of having single counterparty is that offsetting

trades would be netted together. Thus if you bought and sold


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protection on identical terms, the two contracts would cancel

out and you would end up with no outstanding contracts, rather

than two separate contracts. This would eliminate the vast

majority of counterparty risk.

Of course, all trades between counterparty and the central

counterparty would be collateralized and subject to daily

margining as the mark-to-market of those trades moved. It is

likely that the central counterparty would demand initial margin as

well.

There are four firms either trying or has been successful to set up

a central counterparty for CDS. They are -

ICE Trust CME Group Inc./ Citadel InvestmentGroup

Eurex AG NYSE Euronext & LCH.Clearnet SA


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THE INDIAN MARKET

Credit Derivatives Market in India

Banks are major players in the credit market and are, therefore,

exposed to credit risk. Credit market is considered to be an

inefficient market with market players like banks and financial

institutions mostly have loans and little of bonds in their

portfolios while 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 ofloans portfolios. The market in the past did not provide the

necessary credit risk protection to banks and financial

institutions. Neither did it provide any mechanism to the

mutual funds, insurance companies, pension funds and hedge

funds to have an access to loan market to diversify their risks and

earn better return. Credit derivatives were, therefore, developed

to provide a solution to the inefficiencies in the credit market.Internationally, banks are able to protect themselves from the

credit risk through the mechanism of credit derivatives. However,

credit derivative has not yet been used by banks and financial

institutions in India in a formal way.

Benefits from Credit Derivatives:

Banks and Financial Institutions currently require a mechanismthat would allow them to provide long term financing without

taking the credit risk if they so desire. Currently banks and

financial institutions need to hold their portfolios on books

depriving them of diversifying the portfolio as well as making

them forgo some of the opportunities. Also non-banking


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BOND MARKET IN INDIA

Why bond market is not developed in India

1.1951 inception of planning era Birth of DFI (DevelopmentFinancial Institutions) Motive of DFI is to provide long term

funds to industries DFI supported by Budgetary policies and

RBI for funds Corporate got easy access to long term loans

hence Corporate didnt go for public debt

2.Recent times withdrawal of budgetary support to DFI DFIstarted to convert into Commercial banks (to access public

deposit mechanism + lending in short and long term)

Commercial Banks prefer loans than investing in bonds because

later needs Mark-to-market requirements and provisions for

valuation lossLess investment in corporate bonds

3. Institutional buyers are more informed than retail investors tomake investment decision. Hence majority retail investors stay

away from corporate bonds and so as corporate from retail

investors.

Retailers should get better returns with safety while

investing in corporate bonds in order to get retail

participation.

4.Strict regulations of SEBI and RBI make it cumbersome for thecorporate to issue debt papers due to too many mandatory

disclosures


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5.SEBI directive issued in 2004 All secondary market tradingneed to be registered on automated screens of stock

exchangesThis was incorporated to bring in transparency

Not applicable to SPOT trades which are between 2 investors

and are settled in 2 daysMajor investors of bond market i.e.

institutions dont prefer to go on stock exchange screen, resort

to bilateral SPOT trade Brokers depict this as Direct sale

instead of issuing Contract notes, thus not liable to even report

these trades to stock exchange Expected transparency not

observed poor price discovery Low sentiments of public

towards trading in secondary bond market

6.Easy to manage few number of investors like banks, QIB thanlarge number of public holding bonds

7.Option of equity money e.g. IPO, FPO etc8.Few banks/Institutions in secondary market tend to hold

debt paper rather than trading poor liquidity in secondary

bond marketlow number of retail investors

9.Few banks/Institutions in secondary market tend to holddebt paper rather than trading poor liquidity in secondary

bond marketlow number of retail investors

10. No structured Clearing and Settlement system

11. Seller has to first transfer the bond before getting price inhand


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12. Well developed primary & secondary equity market13. Poor knowledge of debt market among investors

14. Since the market is illiquid, the period for holdingthe bond till maturity is long. This is really long

period for blocking the fund from Indian investors

point of view.

15. Derivatives only offer inflation hedging for principalwhile coupons for bond were left unprotected against

inflation

NEW GUIDELINES FOR CDS :

RBI has allowed the FIIs to trade in the CDS market which is agood move in order to ensure the success of the market. It also

necessary as recently RBI has hiked the FII limit in corporate

bonds by USD20 bn and the FIIs are eager to get a slice of the

Indian debt market. Presence of credit risk hedging option would

encourage FII interest in corporate bonds further.

RBI has permitted commercial banks, PDs, Mutual Funds,

Insurance Cos, Housing Finance Cos, PFs and listed corporate and

thus ensured that all the debt market participants are given an

opportunity to hedge their credit risk.

RBI after consultation with the state run banks amended the

earlier requirement for market maker wherein the minimum


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capital to risk weighted assets ratio was relaxed by 1% to 11% and

also the core Tier 1 CRAR was relaxed by 1% to 7%.

In response to the global criticism of CDS the RBI has made sure

not to permit CDS on illiquid underlyings like ABS, MBS,

convertible bonds etc. CDS is also not allowed to be part of anyother structured offering.

It is expected that FIMMDA would set market standards for CDS

valuation and would also, as directed by the RBI, publish the CDS

spreads curve. FIMMDA & RBI need to pay more attention to this

area as the CDS valuation is very complex; with kind of spreads/

default probabilities to be used and the recovery rates to be used,

lien/ seniority of the underlying bond

METHODOLOGY

The method used for the study of the topic credit default swaps

was QUESTIONNAIIRE METHOD.

This questionnaire was filled by the different department

employees of various corporate,banks The targetaudience were

the employees at different level of hierarchy ie. Ranging from

president (top management) to manager level (middle level

management). Sample size included employees from departments

like treasury, bond market dealers vice presidents /managers. Itwas observed that those who were the part of questionnaire were

in age group of 30 yrs. to 40 yrs. It was observed from the

conversation with them that all had fair amount of experience at

their respective positions, thus they can explain what causes them

stress most during the work time & how they reduce it.


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This questionnaire throws a light on

Will credit default swaps deepens the bond market Are the issued guidelines of RBI stringent Will CDS be able to survive in illiquid and under developed

bond market Will users will be able to access CDS and take advantage What measures should be taken by RBI to create awareness

among market makers and users.

GRAPHICAL REPRESENTATION :

SECTION 1 : REGULATIONS

7, 100%

0, 0%0, 0%

1. Do you think lack of liquidity in corporate marketis a big hurdle for development of CDS in India?

YES

NO

OTHER OPINION


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6, 86%

1, 14%

0, 0%

2. Eligibility criteria for market maker is proper

in an initial stage of CDS?

YES

NO

OTHER OPINION

6, 86%

1, 14%

0,

0%

3. Should SEBI and RBI make mandatory disclosure

of CDS exposure in detail in annual report?

YES

NO

OTHER OPINION


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SECTION 2 : USERS

6, 86%

1, 14%

0, 0%0,

0%

4. To what extent do you feel Credit rating

agencies rating actions will have major impact on

investor/traders mind?

SIGNIFICANT

MEDIUM

HARDLY ANYTHING

NOT ATALL

0, 0%

1, 14%

5, 72%

1, 14%

1. What are your opinions on chances of successful

CDS market in India where underlying bond market

relatively illiquid and nascent?

VERY

HIGH

HIGH

LOW

VERY

LOW


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1, 14%

5, 72%

1, 14%

2. Do you think given number of probable market

makers (banks/FII etc.) are enough for

development of CDS market?

YES

NO

OTHER OPINION

1, 14%

5, 72%

1, 14%

0, 0%

3. What would be in your opinion ,the response ofInfrastructure companies, pension funds, insurance

companies to the CDS market?

VERY HIGH

HIGH

LOW

VERY LOW


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SECTION 3: EXPECTATIONS

7, 100%

00

1. Do you think introduction of CDS will add to the

depth of Bond market?

YES

NO

OTHER OPINION

7, 100%

0, 0% 0, 0%

2. With introduction of CDS, do you think issuersother than AAA rated issuers will have more access

to bond market?

YES

NO

OTHER OPINION


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FINDINGS

REGULATIONS:

1.Lack of liquidity in corporate band in India is a big hurdle fordevelopment of CDS in India.

2.The eligibility criteria for market makers as per newguidelines dated 23

rdMay is proper in an initial stage of CDS.

3.SEBI and RBI should make mandatory disclosure of CDSexposure in detail in Annual Reports.

4.Credit rating agencies actions will play a major impact oninvestors mind. Thus if rating agencies will do poor job, then

it will have adverse effect on CDS market. Along with this

,an introduction to CDS will make a way, more accessible to

Bond market for the issuers other than AAA rated issuers.

4, 57%

0, 0%

3, 43%

4. as an organisation, will you be interested in

entering into CDS do in the first year?


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USERS :

5.Many of then are with the opinion that since the market isnascent and relatively illiquid the chances of having

successful CDS market in India is LOW.

6.The number of probable market makers like banks ,FII arenot enough for the development of CDS market. More

flexibility in dealing with CDS and more awareness should be

provided in order to increase the number of participants i.e.

Market makers and users.

7.This credit derivative will be handy for Infrastructurecompanies, pension funds, insurance companies

EXPACTATIONS :

8.Definitely , with an introduction of CDS will deepen the Bondmarket. Many of them are of opinion that it will also reduce

the cost of borrowings for corporate.

9.Allowing to buy Naked CDS will a bad option for RBI.10. MEASURES NEEDS TO BE TAKEN TO EDUCATE THE USERS

ABOUT BOND AND CDS ARE :Training on CDS , risk managementOverseas CDS market study (from Indian perspective )


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CONCLUSION :

The RBI has came with new guidelines with reference to CDS on

23rd

may,2011. Many of the users and market makers found

eligible criteria sufficient at initial stage. With introduction of CDS,

it will deepen the bond market, also reduces the cost of

borrowings. It will provide the way for FII, infrastructure

companies, pension funds, insurance companies. The bond

market in India is illiquid, underdeveloped and lacks high number

of participants. Thus chances of having successful CDS market is

LOW. However some of them were with an opinion that bond

market will in increase in future with more participants. The credit

rating agencies activities will play a major role for the investors.

Most of them are looking forward to this new credit derivative.


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SECTION 3 : EXPECTATIONS

1. Do you think introduction of CDS will add to the depth of Bondmarket?

YES NO

OTHER OPINION :...................................................................

2. With introduction of CDS, do you think issuers other than AAArated issuers will have more access to bond market?

YES NO

OTHER OPINION :...................................................................

3. Do you think introduction of CDS will reduce cost of borrowings forcorporate?

YES NO

OTHER OPINION :....................................................................

4. Do you think that RBI should allow buying of naked CDS (purchaseof credit protection without holding the underlying bond) by users?

YES NO

OTHER OPINION :....................................................................

5.

As an organization, will you be interested in entering in to CDStransaction in the first year of its launch?

YES NO

OTHER OPINION :...................................................................


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6. What measures should be taken by RBI and bodies to educate usersabout bond and CDS?

.........................................................................................................

.........................................................................................................

.........................................................................................................

........................................................................................................

7. In your opinions, what are the specific rules / provisions in the RBIsguidelines for CDS which could hamper the growth of CDS market in

India?

.........................................................................................................

.........................................................................................................

.........................................................................................................

SECTION 4 : WHATS YOUR VIEW

1. Effect of CDS on Indian economy ?.........................................................................................................

.........................................................................................................

.........................................................................................................

........................................................................................................

.........................................................................................................


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Final Cds Summer

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