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1/17
Introduction:
Credit Derivatives are contracts that help an
investor with a given type of risk appetite to
transfer a loan's / bond's inherent credit risk to
another investor with a different risk appetite while
keeping the ownership of the underlying
loan/bond. It is a protection against the failure of
the borrower of the loan or issuer of the bond to
honor its commitment on the expected dates of
recovery/payments. Global credit derivatives
market has grown significantly over last one decadeor so but the growth was halted due to the
unfolding of the financial crisis. According to
e st im at es , t he g ro ss not io na l a mo unt o f
outstanding credit derivative instruments
increased from US$2 trillion at the end of 2002 to
more than US$30 trillion by the end of 2009, after
reaching a peak of US$58 trillion in 2007. A
significant part of the market is concentrated on
credit instruments related bonds and loans of US
corporations and mortgages - a sizable portion of
the market currently traded is derived from debt
instruments issued by sovereign debtors .
According to DTCC as of May 26, 2011,the current
value of outstanding credit derivatives on Greece
sovereign debt is $78bn and the same on Italy's
s ov er ei gn d eb t t ot a ls $ 28 4 bn . G l ob al l y,
commercial banks play a very dominant role in the
credit derivatives market. These banks use these
instruments to diversify their risky investmentassets. These products can also be used to decrease
credit-risk exposure in circumstances where banks
may think that the regulatory capital charges
p r e s c r i b e d o n t h e e x p o s u r e t o b e
disproportionately large. Hence credit derivativesare also used as a tool for regulatory arbitrage by
changing the credit risk profile in an investment or
exposure. There are two types of credit risk -
'default' and 'degradation'. Default risk arises when
the borrower of a loan or the issuer of a bond fails
to service the loan/bond on due dates of payment
of principal and interest/coupon. Degradation is
the fall in credit quality of an exposure due to a
credit event. Since the instruments are generally
credit rated by leading credit rating agencies, a fall
in rating is the degradation of credit. These two
risks are different and hence priced differently.
Degradation of credit quality may not mean a
default as the borrower of the loan or the issue of
the bond will pay off at maturity. However, after
degradation, the possibility of default increases and
hence the intrinsic value of the loan/bond
decreases. A default mean loss of value of the loan
or bond excluding the recovery rate arrived out ofqualityof collaterals held against the bond or loan.
Credit derivatives are designed to transfer the risk
from someone who cannot takethe risk to someone
who has higher risk appetite. By paying a premium,
bond holders or loan givers purchase protection
against default of the exposure. These derivatives
can be constructed in the form of forwards, swaps,
and options. The product allows an investor to
reduce or eliminate credit risk or assume credit riskat appropriate price. These contracts can be used as
hedging tools, yield enhancement, cost reduction,
arbitrage, etc.
CREDIT DERIVATIVES - BASIC CONCEPTS
Golaka C Nath.*
*Dr. Golaka C. Nath
The Clearing Corporation of India Limited
is a Senior Vice President, Research & Surveillance, Membership, HRD
5
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The main objective of these products is to enable
the efficient transfer and repackaging of credit
exposure. The definition of credit risk may
encompass all credit related triggers starting from a
spread widening, through a ratings downgrade, all
the way to default. Commercial Banks use these
products to hedge credit risk, reduce risk
concentrations on their balance sheets, and free up
regulatory capital in the process. New Capital
Regulation as per Basel II has put an onus on
commercial banks to look at these products as it
helps to reduce capital in the banks' books. Banks
are major protection buyers and sellers in the
market.
Credit derivative markets provide market
participants important information about the
credit risk pricing and implied risk free rate.
Intuitively, a well-functioning credit derivative
market provides us a reference risk free rate. If an
AAA note is trading at 8.50% p.a. and an investor
holding the same can buy a protection at spread of
100bps to cover the default risk of the note,
effective, the risk free rate is 7.50% p.a. As Gilts in
many markets display coloured rates due to manyregulatory and liquidity factors, a true risk free rate
can be estimated from the credit derivative market.
Many markets use LIBOR swap curve to as the risk-
neutral default-free interest rate.
Credit derivatives are the outcome of several credit
crises in the financial markets. The Latin American
debt crisis of 1980s brought about Brady plan (US
Treasury Secretary Nicholas F Brady) thatattempted to offer credit enhancement to banks in
exchange of their agreement to accept lower claims
against the countries which agreed to introduce
reforms and get funding from IMF and World
Bank. The credit enhancement was done by first
converting the loan exposure of global banks to
Latin American countries into bonds with agreed
reduced amount and then collateralizing the
notional amount with US Treasury zero-bonds
which were purchased with IMF and World Bank
funds. The credit derivatives market in emerging
c ou n tr i es r ec e iv e d m om en t um i n 1 9 97 ,
contemporaneously with the Asian Crisis.
However, there was no standardized agreement to
deal with the disputes. International Swaps and
Derivatives Association (ISDA) first published the
standardized document of credit derivatives in
1999 and the same has reduced the causes of legal
disputes. The recent European sovereign debt crisis
has brought further thrust to this product. The
credit derivatives market has seen the arrival ofelectronic trading platforms such as CreditTrade
( w w w . c re d i t t r ad e . c o m) a n d C r e di t E x
(www.creditex.com). Both have proved successful
and have had a significant impact in improving
price discovery and liquidity in the single-name
default swap market.
In recent months, the European Union is
investigating some leading international banks
(among 16 of the world's leading investmentbanks) over suspicions they colluded and abused
their positions in providing the financial
derivatives many blame for exacerbating the
Eurozone sovereign debt crisis. The inquiry into
credit default swaps (CDS), the controversial
financial contracts designed to allow investors to
insure against debt default, follows accusations
that banks, many of them rescued by their host
governments from collapse, played a part in forcing
Greece and Ireland to seek EU bailout funds (The
Guardian-29April2011).
More recently, swaps have emerged as one of the
most powerful and mysterious forces in the crisis
shaking Greece and other members of the euro
zone. And they have become the subject of antitrust
History of Credit Derivatives:
6
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investigations in both the United States and the
European Union. The financial regulatory reform
bill passed in 2010 called for the creation of new
clearinghouses for derivatives, a class of financial
transaction that includes credit default swaps. The
investigations focus on whether the handful of big
banks that dominate the swaps field have harmed
rival organizations that could compete in markets
for providing information and clearing swaps deals
(The NY Times - Sep 30, 2011). It further reports
that "Credit default swaps are a type of credit
insurance contract in which one party pays another
party to protect it from the risk of default on a
particular debt instrument. If that debt instrument
(a bond, a bank loan, a mortgage) defaults, theinsurer compensates the insured for his loss. The
insurer (which could be a bank, an investment bank
or a hedge fund) is required to post collateral to
support its payment obligation, but in the insane
credit environment that preceded the credit crisis,
this collateral deposit was generally too small. As a
result, the credit default market is best described as
an insurance market where many of the individual
trades are undercapitalized." The role of banks like
Goldman also became the focus of criticism as
Greece, Spain and other southern European
countries found themselves facing a debt crisis.
Over the last decade, Goldman and others helped
the Greek government legally mask its debts so the
nation appeared to comply with budget rules
governing its membership in the euro, Europe's
common currency. In that role, Goldman advised
Greece and, in return, collected hundreds of
millions of dollars in fees from Athens.
Banks and insurance companies are regulated; the
credit swaps market is not. As a result, contracts can
be traded - or swapped - from investor to investor
without anyone overseeing the trades to ensure the
buyer has the resources to cover the losses if the
security defaults. The instruments can be bought
and sold from both ends - the insured and the
insurer. (Time - March 17, 2008).
In India credit derivatives have been allowed to betraded from Oct'11 after a long wait. However,
CDS on Indian companies that have raised funds
from overseas markets through issuance of
Eurobonds are traded on international markets.
The most common credit derivative is a single
name default swap. In a credit default swap (CDS),
one counterparty (known as the 'protection seller')
agrees to make good another counterparty ('the
protection buyer') if a particular borrowing entity
(company or sovereign) ('the reference entity')
experiences one of the number of defined events
('credit events') that indicate it is unable or may be
Credit Derivatives Structure:
Figure 1: Single name Credit Default Swap: Example of a 5 -year 100 million
Company ABC Ltd. Priced at 200bps per annum
1
Premium
--------------------->>Protection Buyer200bps p.a. for 5 years
Protection Seller
2 If credit event happens
Protection Seller
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unable to service its debts (see Figure 1). The
protection seller is paid a fee or premium, typically
expressed as an annualized percentage of the
notional value of the transaction in basis points
and paid quarterly over the lifeof thetransaction.
Both guarantees and credit insurance in a credit
derivative are designed to compensate a protection
buyer for its losses if a credit event occurs. The
contract depends on both the state of the world
(has a credit event occurred or not?) and the
outcome for the buyer (has it suffered losses or
not?).
A CDS is not only 'state-dependent' but 'outcome-
independent'. Cash-flows are triggered by pre-defined credit events regardless of the exposures or
actions of the protection buyer. For this reason,
credit derivatives can be traded on standardized
t e rm s a mo n gs t a n y c ou n te rp a rt i es . T he
commoditization of credit risk the most important
outcome of credit derivative products. The single
name CDS market allows a protection buyer to
strip out the credit risk from an exposures to a
company or country - loans, bonds, trade credit,
counterparty exposures etc - and transfer it using a
single, standardized commodity instrument.
Equally, market participants can buy or sell
positions for reasons of speculation, arbitrage or
hedging - even if they have no direct exposureto the
reference entity. For example, it is straightforward
to go 'short' of credit risk by buying protection
using CDS. Standardization, in turn, facilitates
hedging and allows intermediaries to make markets
by buying and selling protection, running a
'matched' book.
A Collateralized Debt Obligation (CDO) is a credit
derivative is based on a pool of risky assets. It is
created as a fixed income asset. The coupon and
principal payments of these assets are linked to the
actual performance of the underlying pool. These
assets are divided into tranches like senior,
mezzanine and subordinated/equity. As the name
suggests, seniors have the highest right to receive
repayments followed by mezzanine and equity. It is
important to note that a CDO only redistributes
the total risk associatedwith the underlying pool of
assets to the priority ordered tranches. It neither
reduces nor increases the total risk associated with
the pool. The CDOs entered the emerging market
in 1999. They combine securization and credit
derivative technology to tranche a pool of
underlying default/swaps into different classes of
credit risk. The issuer of CDO notes purchases
protection on the reference pool either through a
default swap or by selling credit linked notes. Thedifferent tranches carry rating ranging from triple-
A to single-B. An equity tranche is unrated and
represents the first loss in exchange for the
highest return. A default swap, made with an
external counterparty, represents the super
senior tranche and covers a certain percentage of
the reference portfolio. The proceeds of the notes
are invested in a pool of highly rated government
securities. Principal and interest is paid to the
highest rated notes first, while any losses are borne
by the more junior tranches.
The most striking aspect of credit derivative is its
commoditization. The transfer of credit risk at a
suitable price has been one of the major
achievements. Credit derivative is akin to
insurance where the insurance writer promises to
pay in case of an agreed eventuality during the life
of the contract. However, to provide this insurance,
we need modalities for valuing credit risk. It is clear
that the compensation that an investor receives for
assuming a credit risk and the premium that a
hedger would need to pay to remove a credit risk
must be linked to the size of the credit risk. This can
Credit Risk Framework:
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be defined in terms of:
1) The likelihood of default or probability of
default.
2) The size of the payoff orlossfollowing default.
The probability of default of a risky bond over its
life can be explained with the help of term
structure. We need to know the spot rates or zero
rates applicable to sovereign and credit products to
figure out the probability of default. Table-1 gives
the basis of estimating probability of default in a
very simplistic way. We have taken the term
structure of 3 years for sovereign and AAA credit
curve.
Table-1:
The first thing we need to know is that we need the
sport rates or zero coupon rates for various terms.
Once we have them, then we can estimate the
implied forwards for both sovereign and credit. In
the above example, we have estimated 1X1 forwards
every year going forward. Then we estimate the
probability of survival by using equation:
In the above equation, is the sovereign spot rate
and k is the credit spot rate. The probability of
default is estimated as (1 - Probability of survival).
These probabilities of default pertain to a
particular year. For example, the bond has a chance
of defaulting to the extent of 0.69% in second year.
The cumulative probability of default is estimated
using the following equation:
The conditional probability of default or marginal
probability of default of this bond for various years
(conditional upon that the bond has not defaulted
in any of the previous years) is simply estimated as
the difference between cumulative probabilities of
defaults in consecutive years. Spread for credit
quality plays a very important role in pricing the
default risk. The probability of default we
estimated here is the risk neutral probability of
default. Empirical probability of default may vary
as it depends on many other factors like business
cycle, liquidity, policy for easy credit, etc. When the
gap between the sovereign and credit curves widen
due to many economic reasons, the cumulative
probabilities of default magnifies. Table - 2 gives an
example of the impact of widening spread on
cumulative probability of default.i
Years
Parameters estimated 1 2 3
Sovereign Curve 7.60% 7.80% 8.00%
AAA spread 0.45% 0.60% 0.70%
Credit Curve 8.05% 8.40% 8.70%
implied Forwards
Sovereign Curve 7.60% 8.00% 8.40%
Credit Curve 8.05% 8.75% 9.30%
Probability of Survival 99.58% 99.31% 99.18%
Probability of Default 0.42% 0.69% 0.82%
Cumulative Probability of Default 1.10% 1.92%
Conditional Probability of Default 0.69% 0.82%
Cumulative Prob of Default =1- (Prob of Surv in Y1* Prob of Surv in Y2) (2)
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Pc= (p*100*R)+(1-p)*100
(1+i) (3)
10
Another way of explaining the credit spread
charged on credit quality is using a binomial tree.
We will use one-year zero coupon corporate bond.
Let us assume that the probability of default for
this bond is and the recovery rate for this bond in
case of default is R% of the Face value. Let us
assume that this recovery is realized at end of year 1.
We can now use a simple single-period binomial
tree, where the price of our risky bond, P is the
expected payoff at year 1 discounted by the risk-free
rate for thecomparable year.This will give:
For our example, we will assume the recovery rate is
the recovery rate for a senior subordinate at 40%
and the probability of default is 0.42%. The value
of the bond with a possibility of default works out
tobe
The one year sovereign bond will be priced at
92.9368 at a spot rate of 7.6%. Hence the spread for
the credit quality, , can be defined in the followingmanner:
For this the bond, the fair credit spread is 25bps with
an assumption of 40% recovery rate. If the recovery
rate changes, the spread will also undergo change.
p
s
c
AAA Bond
Years 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6
Sovereign Yield 7.22 7.56 7.87 8.06 8.16 8.2 8.25 8.29 8.34 8.39 8.44 8.5
AAA Spread 1 35 40 46 53 58 64 68 74 79 84 91 98
AAA Yield 1 7.57 7.96 8.33 8.59 8.74 8.84 8.93 9.03 9.13 9.23 9.35 9.48
AAA Spread 2 67 89 98 110 128 137 148 165 178 186 195 200
AAA Yield 2 8.24 8.85 9.31 9.69 10.02 10.21 10.41 10.68 10.91 11.09 11.3 11.48
Pc= (0.42%*100*40%)+(1-0.42%)*100) = 92.7046
(1+7.60%)
Pc=100
(1+i) (1+s) (4)
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One can also fairly approximate the credit spread
using the credit triangle formula which states that
the annualized compensation for assuming a credit
risk is equal to the annual probability of default
multiplied by the loss in case of a default (1-
recovery rate). That means our fair spread will be
0.42%*60% =0.25% for this bond. We can solve for
any spread, provided we know the recovery rate,
R, and probability of default, PD. The term (1-R) is
commonly used as Loss Given Default (LGD). The
above is a simple but very powerful tool for the
traders to look at credit spreads and what they
imply about default probabilities and recovery
rates, and vice-versa. Within the credit derivatives
market, understanding such a relationship isessential when thinking about how to price
instruments.
Further, when an entity defaults, all its bonds will
default together and hence all bonds issued by the
entity will have the same credit risk and probability
of default, save only the class of bonds having
different claims on the company's balance sheet. A
senior bond will have higher priority over a
subordinate bond in terms of liquidation recovery.
So using a simple formula we can estimate the
spread the subordinate willpay over the senior.
In our case, if the recovery rate for subordinate is
only 25%, and the senior spread is 0.25%, then the
spread forsubordinate willbe 0.31%.
Credit Transition Matrices are very important and
powerful tools provided by Rating Agencies for
estimating probability of default from the
empirical angle. A transition matrix is nothing but
the possibility of various rating movements of a
bond during one year. The Table-3 gives an exampleof a typical transition matrix.
This tells an investor that a BBB rated paper at the
beginning of the year is likely to maintain its own
rating class to an extent of 89.26% while it is
expected to be downgraded to BB to an extent of
4.44% and it may move to default category to an
extent of 0.22%. Using this matrix, we can fairly
price the BBB bond given the general credit spreads
factored by the market. We will explain with the use
s,Probability of Default and Transition Matrix
Table 3: One Year Ratings Transition Matrix-
Probability of migrating to rating by year end (%)Original
Rating AAA AA A BBB BB B CCC Default
AAA 93.66 5.83 0.4 0.08 0.03 0 0 0
AA 0.66 91.72 6.94 0.49 0.06 0.09 0.02 0.01
A 0.07 2.25 91.76 5.19 0.49 0.2 0.01 0.04
BBB 0.03 0.25 4.83 89.26 4.44 0.81 0.16 0.22
BB 0.03 0.07 0.44 6.67 83.31 7.47 1.05 0.98
B 0 0.1 0.33 0.46 5.77 84.19 3.87 5.3
CCC 0.16 0 0.31 0.93 2 10.74 63.96 21.94
Default 0 0 0 0 0 0 0 100
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of a 5-year BBB 8.56% semi-annual coupon bond
currently trading at 10.12%. As per the transition
matrix, the intrinsic value or fair price of the bond
willbeasperTable-4:
For the default category, we have used the recovery
rate which is 40%. This price of 93.81 works out to
10.17% while the market is trading at 10.12%
(assuming good liquidity and fair demand for this
bond). The market is paying a spread of 0.05%
more for this bond and hence an indication that
the recovery rate is presumed to be more or little
lesspossibility of default.
Transition matrices also give the probability of
default. The last column of the matrix is the
probabilityof default in one year. If we want to find
out the probability of default for more than 1 year
using the same matrix, it is simply a matrix
multiplication and little bit of adjustment using
Grubber and (Last column / (1-PD of first
year)) as given in Table-5.
Pricing of a CDS is best explained with the use of
Merton framework in Black-Scholes pricing
formula for options. Structural models
derive the PD by analyzing the capitalstructure of the firm - value of the assets of
the firm vis--vis value of the debt. Since
equity holders are residual recipients, any
value after the payment of debt is left to the
equity holders. Hence it is an option
framework. Bankruptcy will occur when
the value of the debt will be more than the
value of the assets in the firm. Merton
combined the simple equation, share
holders' equity value = assets value - debt
value, with the original Black-Scholes equation for
valuing a call.
where
and
Suppose we have a company with assets worth of
500million and a single issue of a zero coupon debt
due in 7 years with a face value of 350million. The
asset volatility is 35% and risk free rate is 7.5%. We
need to find the annual cost in basis points of a
credit default swap with quarterly payments. Using
the Merton framework discussed earlier, we can
Pricing and Structuring Credit Default Swap
BBB Corporate Curve Estimated Price Probability * Price
AAA 0.03 9.00% 98.26 0.03
AA 0.25 9.24% 97.33 0.24
A 4.83 9.52% 96.25 4.65
BBB 89.26 10.12% 93.99 83.90
BB 4.44 10.78% 91.59 4.07
B 0.81 11.24% 89.96 0.73
CCC 0.16 18.56% 68.30 0.11
Default 0.22 27.35% 40.00 0.09
Intrinsic Value 93.81
Second Year PD
87.76% 5.46% 1.15% 0.20% 0.06% 0.01% 0.00% 0.00% 0.00%
0.62% 0.04% 6.40% 0.80% 0.11% 0.10% 0.02% 0.02% 0.02%
0.13% 0.00% 84.45% 9.43% 1.10% 0.43% 0.04% 0.11% 0.11%
0.06% 0.00% 8.77% 80.23% 7.74% 1.76% 0.32% 0.54% 0.54%
0.06% 0.00% 1.12% 11.58% 70.16% 12.68% 1.85% 2.44% 2.46%
0.01% 0.00% 0.64% 1.24% 9.76% 71.73% 5.79% 10.67% 11.27%
0.25% 0.01% 0.57% 1.62% 3.61% 16.07% 41.35% 36.56% 46.84%
0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 100.00%
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find out value of d1 = 1.415125924 and d2 =
0.489112965. Using these values for d1 and d2, we
can figure out N(d1) as 0.921484211 and N(d2) as
0.687619138. So the value of the equity is estimated
as 318,374,429 and the present value of the debt
becomes the residual at 181,625,571. If the present
outstanding debt had been a sovereign one, the
present value would have been 207044378. Hence
the difference is the present value of the CDS at
25,418,806. If the payment is amortized over 10
year period paid every quarter, then quarterly
payment become 1,177,880. The spread works out
0.34% per quarter and 1.3462% per year or about
135bps. With this spread, the intrinsic value of the
debt becomes 188,425,508 against the market valueof 181,625,571. If the market value of the debt is
181,625,571, then it is trading the yield of 9.8244%.
If we deduct the CDS spread of 1.3462%, the
implied risk free rate becomes 8.4782% instead of
7.50%.
If we want convert this into another structured
product through an issuance of a bond with a semi-
annual coupon of 8% and yield of 8.35% for 7
years, the present value of the CDS is convertedinto this bond by issuing a face value of 45,065,440
(rounded off to 45,000,000). There are many
possibilities of structuring this deal and making it
more challenging by removing many simplistic
assumptions like zero coupon debt. So the
protection writer will receive a coupon at 8% p.a.
(semi-annually) over next 7 years and finally the
face value of 45million at the expiry of 7 years. The
bond issued for this deal can be rated. Since the
protection write is holding a bond for writing the
credit default swap, he can sell the bond and
transfertherisktosomeonewhowantstotakeit.
Standardized credit derivative products are being
traded on exchanges making it more liquid and
attractive for investors. The premium for a CDS is
known as a CDS spread, and is quoted as an annual
percentage in basis points of the notional amount.
Protection buyers pay the spread on a quarterly
basis. CDS have standard payment dates, namely,
March 20, June 20, September 20, and December
20; these standard payment dates also serve as
standard maturity dates. CDS transacted prior to a
standard payment date are subject to a stub
period up to the first standard payment date and
follow the standard schedule afterwards. A CDS
with a five-year maturity agreed on Oct 1, 2011, for
example, would become effective on Oct 2 with
accrued premium due on Dec 20; subsequent
payments would occur on regular dates after until
maturity on Dec 20, 2016. If the spread for adistressed credit is sufficiently high, the CDS will
trade up-front, that is, the buyer will pay the
present value of the excess of the premium over 500
(100/500 are standard coupons on CDS) basis
points at the beginning of the trade, and pay 500
basispointsperannumforthelifeoftheswap.
There are many benefits in credit derivatives for
users. If used inappropriately, the products can
bring downfall of an organization as selling
protection without proper pricing mechanism can
be dangerous. The usage of credit derivatives has
potentiality for distorting existing risk-monitoring
and risk-management incentives for banks. This
can increase in banks' risk profiles by writing
protection as fees are received upfront to bolster the
bank books. Banks use regulatory arbitrage to their
advantage and hence they may off-load low-risk
assets and replace them with higher-risk assets and
buy credit protection.
The bank's incentive to perform efficient
monitoring function over its loan portfolio may be
s ig ni f ic an t ly c om pro mi se d i f t he b an k
subsequently purchases credit protection on the
Regulatory Issues and Challenges
8/3/2019 CDS A, &
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exposure using credit derivative. Whereas loan sales
and securitizations are structured so that
monitoring incentives are retained by the
originator, credit derivatives typically are not.
Banking supervisors have been supportive of thecredit derivatives market within the confines of
their interpretations of the BIS regulatory capital
framework. Broadly speaking, the regulatory
treatment of credit derivatives depends on whether
the position is uncovered or hedges an existing
position. The regulatory capital charge on an
uncovered position is generally the same as the
charge on an equivalent cash position in the
reference asset.
Banks can diversify their loan portfolios in a more
cost effective manner with the use of credit
derivatives. Banks use funding arbitrage and
product restructuring as a motivation for writing
credit risk. The commoditization of credit risk in
an efficient manner is the most important benefit
of the credit derivative market. Banks can reduce
concentration on credit portfolios by using creditderivatives. Credit derivatives may be used for
regulatory arbitrage so far as capital requirement
under Basel guidelines is concerned. Capital
benefit has been provided through credit
derivatives. If an issuer of the bond is BBB rated
entity while the protection seller is a AAA entity,
the capital requirement may be less if no protection
is bought for this loan. Most bank loans require a
capital of 8% of Risk Weighted Asset value but large
banks using internal credit risk models mayprovide capital on the basis of borrowers'
creditworthiness. These banks will have an
incentive to off-load credit-risk exposure on the
loans for which the internally generated capital
charge is lower than the 8 per cent regulatory
requirement to ensure that the bank's return on
capitalis not diluted.
Credit derivatives allow managers for creating
innovative product-structuring. For example,
suppose that an investor wants to buy a 10-year
bond issued by the Government of India anddenominated in Euros. But Government of India
has no such bond issued. So the investor can buy a
10-year bond issued by the Italy and denominated
in euros. At the same time, the investor can sell 10-
year default protection on the Government of
India. This investment will produce coupon
payments on the Italy bonds and a regular fee for
the default protection seller. In exchange for this
regular fee, the investor will be exposed to the loss if
India defaults on its debt. The profile of net risk
and return for these transactions is very similar to a
10-year, euro-denominated bond issued by India.
Credit derivatives enhance the liquidity and
efficiency of markets for risky products by
facilitating risk transfer and unbundling.
European Sovereign debt crisis of recent times has
brought credit derivative market to the fore front
once again. The CDS spreads have been increasing
for European countries like Greece, Portugal, Italy,
etc. Greece has a total debt of $485billion with
major exposure to France (56.7%), Germany
(33.9%), UK (14.6%), etc. With a possible default in
sight, IMF-EU approved a 3-year $146billion bail
out in May'10 releasing funds in tranches. The
second bail out of $157billion was approved by EU
in July'11. Greece has a 98 percent chance of
defaulting on its debt in the next five years as the
Government failed to reassure investors that the
country can survive the euro-region crisis. It costs a
record $5.8 million upfront and $100,000 annually
to insure $10 million of Greece's debt for five years
using credit-default swaps, up from $5.5 million in
Use of Credit derivatives
European Debt Crisis and Credit Derivatives
8/3/2019 CDS A, &
11/171
advance on Sept. 9, according to CMA. Greek
bonds plunged, sending the 10- year yield to 25
percent for the first time (Bloomberg, Sep 13,
2011). The default probability for Greece is based
on a standard pricing model that assumes investors
would recover 40 percent of the bonds' face value if
the nation fails to meet its obligations. Without the
next tranche of aid from the troika (IMF, EU and
ECB) - 8 billion euros - Greece could immediately
default.
RBI has issued circular to initiate credit derivatives
market in India witheffect from Oct 2011.
Users: - Entities are permitted to enter in CDS
market by buying protection only to hedge
underlying risk on corporate bonds which the
Indian scenario
CDS for Indian Markets - Product Design
Eligible Participants -
CDS of Greece, Italy and Portugul
0
1000
2000
3000
4000
5000
6000
23-Se
p-10
20-O
ct-10
16-N
ov-10
13-D
ec-10
7-Jan
-11
3-Feb
-11
2-Mar-11
29-M
ar-11
25-Ap
r-11
20-M
ay-11
16-Ju
n-11
13-Ju
l-11
9-Aug
-11
5-Sep
-11
Portugal Greece Italy
Probability of Default
0
5
10
15
20
25
23-Sep-1
0
20-Oct-
10
16-Nov
-10
13-Dec-
10
7-Jan
-11
3-Feb
-11
2-Mar-
11
29-Mar-
11
25-Apr
-11
20-May
-11
16-Jun-1
1
13-Jul-1
1
9-Aug
-11
5-Sep
-11
AxisTitle
Portugal Greece Italy
8/3/2019 CDS A, &
12/1716
entities must own. No selling of protection or
shorting is allowed. Exiting the bought
position is allowed only by unwinding the trade
with original counterparty or buy finding other
buyer who otherwise satisfies other relevant
conditions.
o Minimum CRAR of 11 per cent with core
CRAR(TierI)ofatleast7percent;
o Net NPAsoflessthan3 percent.
o Minimum Net Owned Funds of 500
crore;
o Minimum CRARof15 percent;
o NetNPAsoflessthan3 percent; and
o Have robust risk management systems in
place to deal withvarious risks.
o Minimum Net Owned Funds of 500
crore;
o MinimumCRARof15 per cent; and
o Have robust risk management systems in
place to deal withvarious risks.
In case a market-maker fails to meet one or more of
the eligibility criteria subsequent to commencing
the CDS transactions, it would not be eligible tosell new protection. As regards existing contracts,
such protection sellers would meet all their
obligations as perthe contract.
The reference entity in a CDS contract, against
whose default the protection is bought and sold,
shall be a single legal resident entity [the term
resident will be as definedin Section 2(v) of Foreign
Exchange Management Act, 1999] and the directobligor for the reference asset/obligation and the
deliverable asset/obligation.
Market - makers: - Entities permitted to quote
both buy and/or sell CDS spreads. They would
be permitted to buy protection without having
the underlying bond. Commercial Banks,
stand-alone Primary Dealers (PDs), Non-
Banking Financial Companies (NBFCs) having
sound financials and good track record in
providing credit facilities and any other
institution specifically permitted by the
Reserve Bank are allowed to work as market-
makers. Insurance companies and Mutual
Funds would be permitted as market-makers
subject to their having strong financials and
risk management capabilities as prescribed by
their respective regulators (IRDA and SEBI)
and as and when permitted by the respective
regulatory authorities.
Commercial banks who intend to act as market-
makers shall fulfillthe following criteria:
NBFCs having sound financial strength, good
track record and involved in providing credit
facilities may be allowed to act as market-
makers, subject to complying with the
following criteria:
PDs intending to act as market-makers shall
fulfil the following criteria:
CDS will be allowed only on listed corporate
bonds as reference obligations.
However, CDS can also be written on unlisted
but rated bonds of infrastructure companies.Besides, unlisted/unrated bonds issued by the
SPVs set up by infrastructure companies are
also eligible as reference obligation.
In the case of banks, the net credit exposure on
account of such CDS should be within the limit
Eligibility norms for market-makers
Reference entity
Reference obligation (eligible underlying for
CDS) - eligibility criteria
`
`
8/3/2019 CDS A, &
13/171
of 10% of investment portfolio prescribed for
u nlis te d/ unra te d b onds a s p er e xt a nt
guidelines issued by RBI. For this purpose, an
Infrastructure Company would be one which is
engaged in the list of items included in the
infrastructure sector as defined in the DBOD
c i rc u l a r R B I / 2 0 1 0 - 1 1 / 6 8 D B O D
No.Dir.BC.14/13.03.00/ 2010-11 dated July 1,
2010 andupdated from timeto time.
Protection sellers should ensure not to sell
protection on reference entities/obligations on
which there are regulatory restrictions on
assuming exposures in the cash market such as,
the restriction against banks holding unrated
bonds, single/group exposure limits and any
other restriction imposed by the regulators
from time to time.
The users cannot buy CDS for amounts higher
than the face value of corporate bonds held by
them and for periods longer than the tenor of
corporate bonds held by them.
To maintain naked CDS protection i.e. CDS
purchase position without having an eligible
underlying is not allowed.
Proper caveat may be included in the agreement
that the market-maker, while entering into and
unwinding the CDS contract, needs to ensure
that the user has exposure in the underlying.
Further, the users are required to submit an
auditor's certificate or custodian's certificate to
the protection sellers or novating users, ofhaving the underlying bond while entering
into/unwinding the CDS contract.
Users cannot exit their bought positions by
entering into an offsetting sale contract. They
can exit their bought position by either
unwinding the contract with the original
counterparty or, in the event of sale of the
underlying bond, by assigning (novating) the
CDS protection, to the purchaser of the
underlying bond (the transferee) subject to
consent of the original protection seller (the
remaining party).
In case of sale of the underlying, every effort
should be made to unwind the CDS position
immediately on sale of the underlying. The
users would be given a maximum grace period
of ten business days from the date of sale of the
underlying bond to unwind the CDSposition.
The identity of the parties responsible for
determining whether a credit event has
occurred must be clearly defined a priori in the
documentation;
The reference asset/obligation and the
deliverable asset/obligation shall be to a
Requirement of the underlying in CDS
Exiting CDS transactions by users
CDS transactions between related parties
Other Requirements
CDS transactions are not permitted to be entered
into either between related parties or where the
reference entity is a related party to either of the
contracting parties.
Related parties for the purpose of these guidelines
will be as defined in 'Accounting Standard 18 -
Related Party Disclosures'. In the case of foreign
banks operating in India, the term 'related parties'
shall include an entity which is a related party of
the foreign bank, its parent, or groupentity.
The single-name CDS on corporate bonds should
also satisfy the following requirements:
The user (except FIIs) and market-maker shall
be resident entities;
8/3/2019 CDS A, &
14/1718
resident and denominated in Indian Rupees;
The CDS contract shall be denominated and
settledin Indian Rupees;
O b li g a t i on s s u c h a s a s se t - b a ck e d
s e c u r i t i e s / mo r t g a g e - b a c k ed s e c u r i t i e s ,convertible bonds and bonds with call/put
options shall not be permitted as reference and
deliverable obligations;
CDScannot be written on interest receivables;
CDS shall not be written on securities with
original maturity up to one year e .g .,
Commercial Papers (CPs), Certificate of
D e po s it s ( CDs ) a nd N o n- Conv er t ib le
Debentures (NCDs) with original maturity upto one year;
The CDS contract must represent a direct claim
on the protection seller;
The CDS contract must be irrevocable; there
must be no clause in the contract that would
allow the protection seller to unilaterally cancel
the contract. However, if protection buyer
defaults under the terms of contract, protection
seller can cancel/revoke the contract;
The CDS contract should not have any clause
that may prevent the protection seller from
making the credit event payment in a timely
manner, after occurrence of the credit event and
completion of necessary formalities in terms of
the contract;
The protection seller shall have no recourse to
the protection buyer for credit-event losses;
dealing in any structured financial productwithCDS as one of the components shallnot be
permitted; and dealing in any derivative
product where the CDS itself is an underlying
shall not be permissible.
The credit events specified in the CDS contract
may cover: Bankruptcy, Failure to pay,
R e p u di a t i o n/ m o r a to r i u m, O b l i g at i o n
acceleration, Obligation default, Restructuring
approved under Board for Industrial and
F i na n ci a l R e co n st r uc ti o n ( BI F R) a n d
Co rp o ra t e D e bt R e st r uc t ur i ng ( CDR )
mechanism and corporate bond restructuring.
The contracting parties to a CDS may include
all or any of the approved credit events
Succession event: Participants may adhere to
the provisions given in the Master Agreement
for CDSprepared by FIMMDA.
D e t e r m i n a t i o n C o m m i t t e e : T h e
Determination Committee (DC) shall be
formed by the market participants andFIMMDA. The DC shall be based in India and
shall deliberate and resolve CDS related issues
such as Credit Events, CDS Auctions,
Succession Events, Substitute Reference
Obligations, etc . The decisions of the
Documentation
Standardization of the CDS Contract
Credit Events
Fixed Income Money Market and Derivatives
Association of India (FIMMDA) shall devise a
Master Agreement for Indian CDS. There would be
two sets of documentation: one set coveringtransactions between user and market-maker and
the other set covering transactions between two
market-makers.
The CDS contracts shall be standardized. The
standardization of CDS contracts shall be achieved
in terms of coupon, coupon payment dates, etc. as
put in place by FIMMDA in consultation with the
market participants.
8/3/2019 CDS A, &
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Committee would be binding on CDS market
participants. In order to provide adequate
representation to users, at least 25 per cent of
the members should be drawn from the users.
The parties to the CDS transaction shall
determine upfront, the procedure and method
of settlement (cash/physical/auction) to be
followed in the event of occurrence of a credit
event and document the same in the CDS
documentation.
For transactions involving users, physical
s et tl em en t i s m an da to ry . F or o th er
transactions, market-makers can opt for any of
the three settlement methods (physical, cash
a n d a u ct i on ) , p ro v i d ed t h e C D S
documentation envisages such settlement.
While the physical settlement would require the
protection buyer to transfer any of the
deliverable obligations against the receipt of its
full notional / face value, in cash settlement, the
protection seller would pay to the protection
buyer an amount equivalent to the lossresulting from the credit event of the reference
entity.
Auction Settlement: Auction settlement may be
conducted in those cases as deemed fit by the
DC. Auction specific terms (e.g. auction date,
time, market quotation amount, deliverable
obligations, etc.) will be set by the DC on a case
by case basis. If parties do not select Auction
Settlement, they will need to bilaterally settle
their trades in accordance with the Settlement
Method (unless otherwise freshly negotiated
between the parties).
Market participants shall use FIMMDA
published daily CDS curve to value their CDS
positions. Day count convention may also be
decided by FIMMDA in consultation with
market participants. However, if a proprietary
model results in a more conservative valuation,
the market participant can use that proprietary
model.
For better transparency, market participants
using their proprietary model for pricing in
accounting statements shall disclose both the
proprietary model price and the standard
model price in notes to the accounts that
should also include an explanation of the
rationale behind using a particular model over
another.
Protection seller in the CDS market shall have
in place internal limits on the gross amount of
protection sold by them on a single entity as
well as the aggregate of such individual grosspositions. These limits shall be set in relation to
their capital funds. Protection sellers shall also
periodically assess the likely stress that these
gross positions of protection sold, may pose on
their liquidity position and their ability to raise
funds, at short notice.
Settlement methodologies
Accounting
Pricing/Valuation methodologies for CDS
Prudential norms for risk management in CDS
Counterparty Credit Exposures
The accounting norms applicable to CDS contracts
shall be on the lines indicated in the 'Accounting
S ta nda rd A S- 30 - Fina nc ia l I nst r um ent s:
Recognition and Measurement', 'AS- 31, FinancialInstruments: Presentation' and 'AS-32 on
Disclosures' as approved by the Institute of
Chartered Accountants of India (ICAI).
8/3/2019 CDS A, &
16/1720
Computation of Credit Exposure
Collateralization and Margining
Market Risk Exposure
Risk Management - Role of Board and Senior
Management
Ceilings for all fund-based and non-fund based
exposures including off-balance sheet exposures
should be computed in relation to total capital
as defined under the extant capital adequacystandards. The protection seller shall treat his
exposure to the reference entity (on the
protection sold) as his credit exposure and
aggregate the same with other exposures to the
reference entity for the purpose of determining
various prudential limits like single / group
exposure, capital market exposure, real estate
exposure, exposure to NBFCs etc.
For CDS transactions, the margins would be
m a int ai ned b y t h e i ndi v id ua l m a rk et
participants. In this regard, market participants
shall adhere to the following requirements:
The quantum of CDS protection sold (net) on a
reference entity shall be taken as actual credit
exposure to the reference entity and thereby
would be covered under the relevant regulatory
exposure limits.
Protection sellers, with the approval of their
Board, shall fix a limit on their Net Long risk
position in CDS contracts, in terms of Risky
PV01, as a percentage of the Total Capital
Funds. (Net long position is the total CDS sold
positions netted by the CDS bought positions
of the same reference entity)
Since CDS represents idiosyncratic risk on
individual obligors, no netting of Risky PV01
across obligors is allowed.
The gross PV01 of all non-option rupee
derivatives should be within 0.25 per cent of the
net worth of the banks / PDs / NBFCs as on the
last balance sheet date (in terms of circularDBOD. No.BP.BC.53/21.04.157/2005-06 dated
December 28, 2005).
Participants should consider carefully all
related risks and rewards before entering into
CDS transactions. They should not enter into
such transactions unless their management has
the ability to understand and manage properly
the credit and other risks associated withCDS.
Participants which are protection buyers
should periodically assess the ability of the
protection sellers to make the credit event
payment as and when they may fall due.
Participants should be aware of the potential
legal risk arising from an unenforceable
c o nt r ac t , e . g. , d u e t o i n ad e qu a te
documentation, lack of authority for a
counterparty to enter into the contract (or to
transfer the asset upon occurrence of a credit
event), uncertain payment procedure or
inability to determine market value when
required.
o Margins may be maintained on net
exposure to each counterparty on account
of CDS transactions.
o Till the requisite infrastructure is put in
place, the positions should be marked-to-
market daily and re-margined at least on a
weekly basis or more frequent basis as
decided between the counterparties.
o Participants may maintain margins in cash
or Government securities.
As regards capturing of market risk, participants
may adhere to the following:
8/3/2019 CDS A, &
17/17
Policy requirements
Reporting Requirements
Before actually undertaking CDS transactions,
participants shall put in place a written policy on
CDS which should be approved by their respective
Board of Directors. The Board approved policy onCDS should be reviewed periodically, at least once
in a year. The Board approved risk management
policyshould cover at the minimum:
o Market-makers shall report their CDS
trades with both users and other market-
makers on the reporting platform of CDS
trade repository within 30 minutes from
the deal time.
o The users would be required to affirm or
reject their trade already reported by the
market- maker by the end of the day.
o In the event of sale of underlying bond by
the user and the user assigning the CDS
protection to the purchaser of the bond
subject to the consent of the original
protection seller, the original protection
seller should report such assignment tothe trade reporting platform and the same
should be confirmed by both the original
user and the new assignee.
In addition to the reporting done on the trade
reporting platform, the participants shall also
report to their regulators information as required
by them such as risk positions of the participants
vis--vis their net-worth and adherence to risk
limits, etc. As regards the Reserve Bank regulated
entities, the information shall be reported to the
respective regulatory department of the Reserve
Bank on a fortnightly basis, within a week after the
end of fortnight, as perthe proforma given.
The strategy - i.e., whether CDS would be used
for hedging or for trading, risk management
and limits for CDS;
Authorization levels for engaging in such
business and identification of those responsible
for managing it;
P ro ce du re for m ea su r ing , m oni to ri ng,
reviewing, reporting and managing the
associated risks like credit risk, market risk,
liquidity risk and other specific risks;
Appropriate accounting and valuation
principles for CDS;
Determination of contractual characteristics of
the product; and
Use of best market practices.
Trade Reporting
Supervisory Reporting
Recommended