CDS Edited Dupe

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Credit Derivative

A Credit Derivative is a financial instrument used to moderate or toassume specific forms of credit risk by hedgers and speculators.

A credit derivative is a derivative whose value derives from the creditrisk on an underlying bond, loan or other financial asset.

In this way, the credit risk is on an entity other than the counterpartiesto the transaction itself.

This entity is known as the reference entityand may be a corporate, asovereign or any other form of legal entity which has incurred debt.

Credit derivatives are bilateral contracts between a buyer and sellerunder which the seller sells protection against the credit risk of thereference entity.

The parties will select which credit events apply to a transaction andthese usually consist of one or more of the following:

Bankruptcy - The risk that the reference entity will becomebankrupt.

Failure to pay - The risk that the reference entity will default onone of its obligations such as a bond or loan.

Obligation default - The risk that the reference entity will defaulton any of its obligations.

Obligation acceleration - The risk that an obligation of thereference entity will be accelerated e.g. a bond will be declaredimmediately due and payable following a default.

Repudiation/moratorium - The risk that the reference entity or agovernment will declare a moratorium over the reference entity's

obligations. Restructuring - The risk that obligations of the reference entity

will be restructured.

Where credit protection is bought and sold between bilateralcounterparties this is known as an unfunded credit derivative.

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If the credit derivative is entered into by a financial institution or aspecial purpose vehicle (SPV) and payments under the credit derivativeare funded using securitization techniques, such that a debt obligationis issued by the financial institution or SPV to support these obligations,

this is known as a funded credit derivative.This synthetic securitization process has become increasingly popularover the last decade, with the simple versions of these structures beingknown as synthetic CDOs; credit linked notes; single tranche CDOs, toname a few. In funded credit derivatives, transactions are often ratedby rating agencies, which allows investors to take different slices ofcredit risk according to their risk appetite.

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Market Size And Participants

Local banks can take advantage of their informational edge in terms ofassessing the default risk and recovery rates in their regional market.

Credit default products are the most commonly traded creditderivative product and include unfunded products such as CreditDefault Swaps and funded products such as Collateralized DebtObligations.

The International Swap and Derivatives Association reported in April

2007 that total notional amount on outstanding credit derivatives was$35.1 trillion with a gross market value of $948 billion.

As reported in Times Sept. 15.08 "Worldwide credit derivatives marketis valued at $62 trillion". Although the credit derivatives market is aglobal one, London has a market share of about 40%, with the rest ofEurope having about 10%.

The annual growth rate for credit derivatives is 75% from $26.0 trillionat mid-year 2006. Credit derivatives have been growing at an annual

rate of nearly 100% over the past 3-4 years.

The primary purpose of credit derivatives is to enable the efficienttransfer and repackaging of credit risk.

Banks in particular are using credit derivatives to hedge credit risk,reduce risk concentrations on their balance sheets, and free upregulatory capital in the process

These products are particularly useful for institutions with widespread

credit exposures. The main market participants are banks, hedgefunds, insurance companies, pension funds, and other corporates.

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Growth in Credit Derivatives (as per British BankersAssociation - Credit Derivatives Report 2006)

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Market Structure with regards to sellers of CreditDerivatives.

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Types Of Credit Derivatives.

In their simplest form, Credit Derivatives provide a more efficient wayto replicate in a derivative form the credit risks that would otherwise

exist in a standard cash instrument

Credit derivatives are fundamentally divided into two categories:Funded Credit Derivatives and Unfunded Credit Derivatives.

An unfunded credit derivative is a bilateral contract between twocounterparties, where each party is responsible for making itspayments under the contract (i.e. payments of premiums and any cashor physical settlement amount) itself without recourse to other assets.

Unfunded credit derivative products include the following products:

Credit default swap (CDS) Total return swap First to Default Credit Default Swap Portfolio Credit Default Swap Secured Loan Credit Default Swap Credit Default Swap on Asset Backed Securities Credit default swaption

Recovery lock transaction Credit Spread Option CDS index products Constant Maturity Credit Default Swap (CMCDS)

A funded credit derivative involves the protection seller (the partythat assumes the credit risk) making an initial payment that is used tosettle any potential credit events. The advantage of this to theprotection buyer is that it is not exposed to the credit risk of the

protection seller.Funded credit derivative products include the following products:

Credit linked note (CLN) Synthetic Collateralized Debt Obligation (CDO) Constant Proportion Debt Obligation (CPDO)

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Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)

Key Unfunded Credit Derivative Products

Credit Default Swap

The credit default swap or CDS has become the cornerstone product ofthe credit derivatives market. This product represents over thirtypercent of the credit derivatives market.

A credit default swap, in its simplest form (the unfunded single namecredit default swap) is a bilateral contract between aprotection buyerand aprotection seller. The credit default swap will reference thecreditworthiness of a third party called a reference entity this willusually be a corporate or sovereign. The credit default swap will relateto the specified debt obligations of the reference entity, perhaps itsbonds and loans, which fulfill certain pre-agreed characteristics.

The protection buyer will pay a periodic fee to the protection seller inreturn for a contingent payment by the seller upon a credit event

affecting the obligations of the reference entityspecified in thetransaction.

The relevant credit events specified in a transaction will usually beselected from amongst the following:

The bankruptcy of the reference entity; its failure to pay in relation toa covered obligation; it defaulting on an obligation or that obligationbeing accelerated; it agreeing to restructure a covered obligation or arepudiation or moratorium being declared over any covered obligation.

If any of these events occur and the protection buyer serves a creditevent notice on the protection seller detailing the credit event as wellas (usually) providing some publicly available information validatingthis claim, then the transaction will settle.

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This means that, in the case of a physically settled transaction, theprotection buyer can deliver an amount of the reference entity'sdefaulted obligations to the protection seller, in return for their fullface value (notwithstanding that they are now worth far less).

In the case of cash settled transaction, a relevant obligation of thereference entity will be valued and the protection seller will pay theprotection buyer the full face value of the reference obligation less itscurrent value (i.e. compensating the protection buyer for the declinein the obligation's creditworthiness).

Credit default swaps have unique characteristics that distinguish themfrom Insurance products and Financial guaranties.

The protection buyer does not need to own an underlying obligation ofthe reference entity.

The protection buyer does not need to suffer a loss. The protectionseller has no recourse to and no right to sue the reference entity forrecovery.

The product has many variations, including where there is a basket orportfolio of reference entities, although fundamentally, the principlesremain the same. A powerful recent variation has been gathering

market share of late: credit default swaps which relate to asset-backedsecurities.

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Key Funded Credit Derivative Products

Credit Linked Notes

In this example coupons from the bank's portfolio of loans are passed tothe SPV which uses the cash flow to service the credit linked notes.

A credit linked note is a note whose cash flow depends upon an event,which may be a default, change in credit spread, or rating change. Thedefinition of the relevant credit events must be negotiated by theparties to the note.

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A CLN in effect combines a credit-default swap with a regular note(with coupon, maturity, redemption). Given its note like features, aCLN is an on-balance-sheet asset, in contrast to a CDS.

Typically, an investment fund manager will purchase such a note tohedge against possible down grades, or loan defaults.

Numerous different types of credit linked notes (CLNs) have beenstructured and placed in the past few years. Here we are going toprovide an overview rather than a detailed account of theseinstruments.

The most basic CLN consists of a bond, issued by a well-rated borrower,packaged with a credit default swap on a less creditworthy risk.

For example, a bank may sell some of its exposure to a particularemerging country by issuing a bond linked to that country's default orconvertibility risk. From the bank's point of view, this achieves thepurpose of reducing its exposure to that risk, as it will not need toreimburse all or part of the note if a credit event occurs. However,from the point of view of investors, the risk profile is different fromthat of the bonds issued by the country. If the bank runs into difficulty,their investments will suffer even if the country is still performing well.

The credit rating is improved by using a proportion of governmentbonds, which means the CLN investor receives an enhanced coupon.

Through the use of a credit default swap, the bank receives somerecompense if the reference credit defaults.

There are several different types of securitized product, which have acredit dimension. CLN is a generic name related to any bond whosevalue is linked to the performance of a reference asset, or assets. Thislink may be through the use of a credit derivative, but does not have tobe.

Credit-linked notes CLN: Credit-linked note is a generic namerelated to any bond whose value is linked to the performance of areference asset, or assets. This link may be through the use of acredit derivative, but does not have to be.

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Collateralized debt obligation CDO: Generic term for a bondissued against a mixed pool of assets.

Collateralized bond obligations CBO: Bond issued against a pool ofbond assets or other securities. It is referred to in a generic sense

as a CDO Collateralized loan obligations CLO: Bond issued against a pool ofbank loan. It is referred to in a generic sense as a CDO

CDO refers either to the pool of assets used to support the CLNs or,confusingly, to the CLNs themselves.

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Collateralized Debt Obligations (CDO)

Collateralized debt obligations or CDOs are a form of credit derivativeoffering exposure to a large number of companies in a singleinstrument. This exposure is sold in slices of varying risk orsubordination - each slice is known as a tranche.

In a cash flow CDO, the underlying credit risks are bonds or loans heldby the issuer. Alternatively in a synthetic CDO, the exposure to eachunderlying company is a credit default swap. A synthetic CDO is alsoreferred to as CSO.

Other more complicated CDOs have been developed where eachunderlying credit risk is itself a CDO tranche. These CDOs arecommonly known as CDOs-squared.

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Risks

Risks involving credit derivatives are a concern among regulators offinancial markets.

The US Federal Reserve issued several statements in the Fall of 2005about these risks, and highlighted the growing backlog of confirmationsfor credit derivatives trades.

These backlogs pose risks to the market (both in theory and in alllikelihood) and they intensify other risks in the financial system.

One challenge in regulating these and other derivatives is that thepeople who know most about them also typically have a vestedincentive in encouraging their growth and lack of regulation.

The incentive may be indirect, e.g., academics have not onlyconsulting incentives, but also incentives in keeping open doors forresearch.

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What about the Indian market?India has yet to realize the power of the credit derivative market. Oflate, Reserve Bank of India has come out with a draft proposal in thisregard which has recognized that though banks are dominant players inthe loan market and thus are substantially exposed to credit risk, themarket has not provided provide adequate protection against the creditrisk to commercial banks.

This gap, as observed by RBI, can substantially be bridged through the

introduction of credit derivatives which can involve other dominantmarket players such as insurance companies, mutual funds andcorporate sector in these transactions.

Credit derivatives, if introduced, can not only supplement the ongoingprocess of securitization but also help reduce the inefficiencies in theexisting loan market.

This, however, presupposes the existence of a sound regulatory setupto address the legal and documentation issues involving creditderivative transactions.

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The Importance Of Credit Derivatives.

Credit derivatives have been widely adopted by credit marketparticipants as a tool for investing in, or managing exposure to

credit. The rapid growth of this market is largely attributable to thefollowing features of credit derivatives:

Credit derivatives provide an efficient way to take credit risk:- Creditdefault swaps represent the cost to assume pure credit risk. Acorporate bond represents a bundle of risks including interest rate,currency (potentially), and credit risk (constituting both the risk ofdefault and the risk of volatility in credit spreads). Before theadvent of credit default swaps, the primary way for a bond investorto adjust his credit risk position was to buy or sell that bond,

consequently affecting his positions across the entire bundle ofrisks. Credit derivatives provide the ability to independentlymanage default and interest rate risks.

Credit derivatives provide ways to tailor credit investments andhedges:- Credit derivatives provide users with various options tocustomize their risk profiles. First, investors may customize tenor ormaturity, and Second, while CDS often refer to a senior unsecuredbond, CDS that reference senior secured, syndicated secured loans(LCDS), and preferred stock (PCDS) commonly trade, allowinginvestors to express views on different parts of a companys capitalstructure. Through the CDS market, investors may customizecurrency exposure, increase risk to credits they cannot source inthe cash market, or benefit from relative value transactionsbetween credit derivatives and other asset classes. Additionally,investors have access to a variety of structures, such as baskets andtranches that can be used to tailor investments to suit the investors

desired risk/return profile.

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Credit derivatives can serve as a link between structurally separatemarkets:- Bond, loan, equity, and equity-linked market participantstransact in the credit default swap market. Because of this centralposition, the credit default swap market will often react faster thanthe bond or loan markets to news affecting credit prices. Forexample, investors buying newly issued convertible debt areexposed to the credit risk in the bond component of the convertibleinstrument, and may seek to hedge this risk using credit default

swaps. As buyers of the convertible bond purchase protection,spreads in the CDS market widen. This spread change may occurbefore the pricing implications of the convertible debt are reflectedin bond market spreads. However, the change in CDS spreads maycause bond spreads to widen as investors seek to maintain the valuerelationship between bonds and CDS. Thus, the CDS market canserve as a link between structurally separate markets. This has ledto more awareness of and participation from different types ofinvestors.

Credit derivatives provide liquidity in times of turbulence in the creditmarkets:- The credit derivative market is able to provide liquidityduring periods of market distress (high default rates). Before thecredit default swap market, a holder of a distressed or defaultedbond often had difficulty selling the bondeven at reduced prices.This is because cash bond desks are typically long risk as they ownan inventory of bonds. As a result, they are often unwilling topurchase bonds and assume more risk in times of market stress. Incontrast, credit derivative desks typically hold an inventory ofprotection (short risk), having bought protection through creditdefault swaps. In distressed markets, investors can reduce long riskpositions by purchasing protection from credit derivative desks,which may be better positioned to sell protection (long risk) andchange their inventory position from short risk to neutral.

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Furthermore, the CDS market creates natural buyers of defaultedbonds, as protection holders (short risk) buy bonds to deliver to theprotection sellers (long risk). CDS markets have, therefore, led toincreased liquidity across many credit markets.

Credit derivatives provide an efficient way to short a credit:- While itcan be difficult to borrow corporate bonds on a term basis or enterinto a short sale of a bank loan, a short position can be easilyachieved by purchasing credit protection. Consequently, riskmanagers can short specific credits or a broad index of credits,either as a hedge of existing exposures or to profit from a negativecredit view.

Credit derivative transactions are confidential:- As with the trading of a bond inthe secondary market, the reference entity whose credit risk is beingtransferred is neither a party to a credit derivative transaction, nor is evenaware of it. This confidentiality enables risk managers to isolate and transfercredit risk discreetly, without affecting business relationships. In contrast, aloan assignment through the secondary loan market may require borrowernotification, and may require the participating bank to assume as much creditrisk to the selling bank as to the borrower itself. Since the reference entity isnot a party to the negotiation, the terms of the credit derivative transaction

(tenor, seniority, and compensation structure) can be customized to meet theneeds of the buyer and seller, rather than the particular liquidity or term needsof a borrower.

Credit Default Swaps.

ACredit Default Swap (CDS) is a credit derivative contract betweentwo counterparties, whereby the "buyer" or "fixed rate payer" pays

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periodic payments to the "seller" or "floating rate payer" in exchangefor the right to a payoff if there is a default or "credit event" in respectof a third party or "reference entity".

If a credit event occurs, the typical contract either settles by deliveryby the buyer to the seller of a (usually defaulted) debt obligation ofthe reference entity against a payment by the seller of the par value("physical settlement") or the seller pays the buyer the differencebetween the par value and the market price of a specified debtobligation, typically determined in an auction ("cash settlement").

A credit default swap resembles an insurance policy, as it can be usedby a debt holder to hedge, or insure against a default under the debtinstrument. However, because there is no requirement to actually hold

any asset or suffer a loss, a credit default swap can also be used forspeculative purposes and is not generally considered insurance forregulatory purposes.

A swap designed to transfer the credit exposure of fixed incomeproducts between parties.

Credit default swaps allow one party to "buy" protection from anotherparty for losses that might be incurred as a result of default by aspecified reference credit (or credits).

The buyer of a credit swap receives credit protection, whereas theseller of the swap guarantees the credit worthiness of the product. Bydoing this, the risk of default is transferred from the holder of thefixed income security to the seller of the swap.

The "buyer" of protection pays a premium for the protection, and the"seller" of protection agrees to make a payment to compensate thebuyer for losses incurred upon the occurrence of any one of severalspecified "credit events."

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For example, the buyer of a credit swap will be entitled to the parvalue of the bond by the seller of the swap, should the bond defaultin its coupon payments.

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Market participants

Credit default swaps are the most widely traded credit derivative product

and the Bank for International Settlements reported the notional amounton outstanding OTC credit default swaps to be $42.6 trillion in June 2007,up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005)and by the end of 2007 there were an estimated USD 45 trillion worth ofCredit Default Swap contracts.

In the US, the Office of the Comptroller of the Currency reported the notionalamount on outstanding credit derivatives from 882 reporting banks to be$5.472 trillion at the end of March, 2006.

Over the last few years, participants profiles have evolved and diversifiedalong with the credit derivatives market itself. While banks remain importantplayers in the credit derivatives market, trends indicate that asset managersshould be the principal drivers of future growth.

Banks and loan portfolio managers:- Banks were once the primaryparticipants in the credit derivatives market. They developed the CDSmarket in order to reduce their risk exposure to companies to whomthey lent money or become exposed through other transactions, thus

reducing the amount of capital needed to satisfy regulatoryrequirements. Banks continue to use credit derivatives for hedging bothsingle-name and broad market credit exposure.

Market makers:- In the past, market markers in the credit markets wereconstrained in their ability to provide liquidity because of limits on theamount of credit exposure they could have to one company or sector.The use of more efficient hedging strategies, including creditderivatives, has helped market makers trade more efficiently whileemploying less capital. Credit derivatives allow market makers to holdtheir inventory of bonds during a downturn in the credit cycle whileremaining neutral in terms of credit risk. To this end, JP Morgan andmany other dealers have integrated their CDS trading and cash tradingbusinesses.

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Hedge funds:- Since their early participation in the credit derivativesmarket, hedge funds have continued to increase their presence andhave helped to increase the variety of trading strategies in the market.While hedge fund activity was once primarily driven by convertible bondarbitrage, many funds now use credit default swaps as the mostefficient method to buy and sell credit risk. Additionally, hedge fundshave been the primary users of relative value trading opportunities andnew products that facilitate the trading of credit spread volatility,correlation, and recovery rates.

Asset managers:- Asset managers are typically end users of risk that usethe CDS market as a relative value tool, or to provide a structuralfeature they cannot find in the bond market, such as a particularmaturity. Also, the ability to use the CDS market to express a bearishview is an attractive proposition for many. For example, an assetmanager might purchase three-year protection to hedge a ten-year bondposition on an entity where the credit is under stress but is expected toperform well if it survives the next three years. Finally, the emergenceof a liquid CDS index market has provided asset managers with a vehicleto efficiently express macro views on the credit markets.

Insurance companies:- The participation of insurance companies in thecredit default swap market can be separated into two distinct groups:

1) life insurance and property & casualty companies and

2) Mono lines and Re insurers.

Life insurance and P&C companies typically use credit default swaps tosell protection (long risk) to enhance the return on their asset portfolioeither through Replication (Synthetic Asset) Transactions ("RSATs", orthe regulatory framework that allows some insurance companies toenter into credit default swaps) or credit-linked notes. Mono lines and

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Re insurers often sell protection (long risk) as a source of additionalpremium and to diversify their portfolios to include credit risk.

Corporations:- Corporations use credit derivatives to manage creditexposure to third parties. In some cases, the greater liquidity,transparency of pricing and structural flexibility of the CDS marketmake it an appealing alternative to credit insurance or factoringarrangements. Some corporations invest in CDS indices and structuredcredit products as a way to increase returns on pension assets orbalance sheet cash positions. Finally, corporations are focused onmanaging funding costs; to this end, many corporate treasurers monitortheir own CDS spreads as a benchmark for pricing new bank and bonddeals.

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Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the2003 Credit Derivatives Definitions as published by the International Swaps

and Derivatives Association. The confirmation typically specifies a referenceentity, a corporation or sovereign that generally, although not always, hasdebt outstanding, and a reference obligation, usually an unsubordinatedcorporate bond or government bond. The period over which defaultprotection extends is defined by the contract effective date and scheduledtermination date.

The confirmation also specifies a calculation agent who is responsible formaking determinations as to successors and substitute reference obligations,and for performing various calculation and administrative functions in

connection with the transaction. By market convention, in contracts betweenCDS dealers and end-users, the dealer is generally the calculation agent, andin contracts between CDS dealers, the protection seller is generally thecalculation agent. It is not the responsibility of the calculation agent todetermine whether or not a credit event has occurred but rather a matter offact that, pursuant to the terms of typical contracts, must be supported bypublicly available information delivered along with a credit event notice.Typical CDS contracts do not provide an internal mechanism for challengingthe occurrence or non-occurrence of a credit event and rather leave the

matter to the courts if necessary, though actual instances of specific eventsbeing disputed are relatively rare.

CDS confirmations also specify the credit events that will trigger a creditevent and give rise to payment obligations by the protection seller anddelivery obligations by the protection buyer. Typical credit events includebankruptcywith respect to the reference entity andfailure to paywithrespect to its direct or guaranteed bond or loan debt. CDS written on NorthAmerican investment grade corporate reference entities, European corporatereference entities and sovereigns generally also include 'restructuring' as a

credit event, whereas trades referencing North American high yield corporatereference entities typically do not. The definition of restructuring is quitetechnical but is essentially intended to pick up circumstances where areference entity, as a result of the deterioration of its credit, negotiateschanges in the terms in its debt with its creditors as an alternative to formalinsolvency proceedings. This practice is far more typical in jurisdictions thatdo not provide protective status to insolvent debtors similar to that provided

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by Chapter 11 of the United States Bankruptcy Code. In particular, concernsarising out of Conseco's restructuring in 2000 led to the credit event's removalfrom North American high yield trades.

Finally, standard CDS contracts specify deliverable obligation characteristicsthat limit the range of obligations that a protection buyer may deliver upon acredit event. Trading conventions for deliverable obligation characteristicsvary for different markets and CDS contract types. Typical limitations includethat deliverable debt be a bond or loan, that it have a maximum maturity of30 years, that it not be subordinated, that it not be subject to transferrestrictions (other than Rule 144A), that it be of a standard currency and thatit not be subject to some contingency before becoming due.

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Pricing and Valuation

There are two competing theories usually advanced for the pricing of creditdefault swaps. The first, which for convenience we will refer to as the'probability model', takes the present value of a series of cash flows weightedby their probability of non-default. This method suggests that credit defaultswaps should trade at a considerably lower spread than corporate bonds.

The second model, proposed by Darrell Duffie, but also by Hull and White,uses a no-arbitrage approach.

Probability model

Under the probability model, a credit default swap is priced using a modelthat takes four inputs:

the issue premium, the recovery rate, the credit curve for the reference entity and the LIBOR curve.

If default events never occurred the price of a CDS would simply be the sumof the discounted premium payments. So CDS pricing models have to take into

account the possibility of a default occurring some time between theeffective date and maturity date of the CDS contract. For the purpose ofexplanation we can imagine the case of a one year CDS with effective date t0with four quarterly premium payments occurring at times t1, t2, t3, and t4. Ifthe nominal for the CDS is Nand the issue premium is c then the size of thequarterly premium payments is Nc / 4. If we assume for simplicity thatdefaults can only occur on one of the payment dates then there are fivewaysthe contract could end: either it does not have any default at all, so the fourpremium paymentsare made and the contract survives until the maturity

date, or a default occurs on the first, second, third or fourth payment date.To price the CDS we now need to assign probabilities to the five possibleoutcomes, then calculate the present value of the payoff for eachoutcome.The present value of the CDS is then simply the present value of the fivepayoffs multiplied by their probability of occurring.

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This is illustrated in the following tree diagram where at each payment dateeither the contract has a default event, in which case it ends with a paymentof N(1 R) shown in red, where R is the recovery rate, or it survives without adefault being triggered, in which case a premium payment of Nc / 4 is made,

shown in blue. At either side of the diagram are the cash flows up to thatpoint in time with premium payments in blue and default payments in red. Ifthe contract is terminated the square is shown with solid shading.

The probability of surviving over the interval ti 1 to ti without a defaultpayment ispi and the probability of a default being triggered is 1 pi. Thecalculation of present value, given discount factors of 1 to 4 is then

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Description Premium Payment PVDefault Payment

PVProbability

Default at timet1Default at timet2Default at timet3Default at timet4

No defaults

The probabilitiesp1,p2,p3,p4 can be calculated using the credit spreadcurve. The probability of no default occurring over a time period from t to t +t decays exponentially with a time-constant determined by the creditspread, or mathematicallyp = exp( s(t)t) where s(t) is the credit spreadzero curve at time t. The riskier the reference entity the greater the spreadand the more rapidly the survival probability decays with time.

To get the total present value of the credit default swap we multiply the

probability of each outcome by its present value to give

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No-arbitrage model

In the 'no-arbitrage' model proposed by both Duffie, and Hull and White, it isassumed that there is no risk free arbitrage. Duffie uses the LIBOR as the riskfree rate, whereas Hull and White use US Treasuries as the risk free rate.Both analyses make simplifying assumptions (such as the assumption thatthere is zero cost of unwinding the fixed leg of the swap on default), whichmay invalidate the no-arbitrage assumption. However the Duffie approach isfrequently used by the market to determine theoretical prices. Under theDuffie construct, the price of a credit default swap can also be derived bycalculating the asset swap spread of a bond. If a bond has a spread of 100,and the swap spread is 70 basis points, then a CDS contract should trade at30. However owing to inefficiencies in markets, this is not always the case.

The difference between the theoretical model and the actual price of a creditdefault swap is known as the basis.

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Uses Of Credit Derivative Swaps.

Like most financial derivatives, credit default swaps can be used to hedgeexisting exposures to credit risk, or to speculate on changes in credit spreads.

Hedging

Credit default swaps can be used to manage credit risk without necessitatingthe sale of the underlying cash bond. Owners of a corporate bond can protectthemselves from default risk by purchasing a credit default swap on thatreference entity.

For example, a pension fund owns $10 million worth of a five-year bond

issued by Risky Corporation. In order to manage the risk of losing money ifRisky Corporation defaults on its debt, the pension fund buys a CDS fromDerivative Bank in a notional amount of $10 million that trades at 200 basispoints. In return for this credit protection, the pension fund pays 2% of 10million ($200,000) in quarterly installments of $50,000 to Derivative Bank. IfRisky Corporation does not default on its bond payments, the pension fundmakes quarterly payments to Derivative Bank for 5 years and receives its $10million loan back after 5 years from the Risky Corporation. Though theprotection payments reduce investment returns for the pension fund, its riskof loss in a default scenario is eliminated. If Risky Corporation defaults on itsdebt 3 years into the CDS contract, the pension fund would stop paying thequarterly premium, and Derivative Bank would ensure that the pension fund isrefunded for its loss of $10 million (either by taking physical delivery of thedefaulted bond for $10 million or by cash settling the difference between parand recovery value of the bond). Another scenario would be if RiskyCorporation's credit profile improved dramatically or it is acquired by astronger company after 3 years, the pension fund could effectively cancel orreduce its original CDS position by selling the remaining two years of creditprotection in the market.

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Speculation

Credit default swaps give a speculator a way to make a large profit fromchanges in a company's credit quality. A protection seller in a credit defaultswap effectively has an unfunded exposure to the underlying cash bond orreference entity, with a value equal to the notional amount of the CDScontract.

For example, if a company has been having problems, it may be possible tobuy the company's outstanding debt (usually bonds) at a discounted price. Ifthe company has $1 million worth of bonds outstanding, it might be possibleto buy the debt for $900,000 from another party if that party is concernedthat the company will not repay its debt. If the company does in fact repaythe debt, you would receive the entire $1 million and make a profit of$100,000. Alternatively, one could enter into a credit default swap with theother investor, by selling credit protection and receiving a premium of$100,000. If the company does not default, one would make a profit of$100,000 without having invested anything.

It is also possible to buy and sell credit default swaps that are outstanding.

Like the bonds themselves, the cost to purchase the swap from another partymay fluctuate as the perceived credit quality of the underlying companychanges. Swap prices typically decline when creditworthiness improves, andrise when it worsens. But these pricing differences are amplified compared tobonds. Therefore someone who believes that a company's credit quality wouldchange could potentially profit much more from investing in swaps than in theunderlying bonds (although encountering a greater loss potential).

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Criticisms

The collapse of Lehman Brothers has triggered an enormous crisis inderivative markets.Prior to the firm's spectacularly swift demise, nomajor counterparty in the world's biggest financial market had ever goneunder. A major counterparty failure threatens the delicate web oftrading in securities that are gargantuan in dollar amounts but totallylacking in transparency to the public.

Warren Buffett famously described derivatives bought speculatively as"financial weapons of mass destruction." In Berkshire Hathaway's annualreport to shareholders in 2002, he said, "Unless derivatives contracts arecollateralized or guaranteed, their ultimate value also depends on the

creditworthiness of the counterparties to them. In the meantime, though,before a contract is settled, the counterparties record profits and losses-often huge in amount- in their current earnings statements without so muchas a penny changing hands. The range of derivatives contracts is limited onlyby the imagination of man (or sometimes, so it seems, madmen)." The samereport, however, also states that he uses derivatives to hedge, and that someof Berkshire Hathaway's subsidiaries have sold and currently sell derivativeswith notional amounts in the tens of billions of dollars.

The market for credit derivatives is now so large, in many instances the

amount of credit derivatives outstanding for an individual name are vastlygreater than the bonds outstanding. For instance, company X may have $1billion of outstanding debt and $10 billion of CDS contracts outstanding. Ifsuch a company were to default, and recovery is 40 cents on the dollar, thenthe loss to investors holding the bonds would be $600 million. However theloss to credit default swap sellers would be $6 billion. When the CDS havebeen made for purely speculative purposes, in addition to spreading risk,credit derivatives can also amplify those risks. If the CDS were being used tohedge, the notional value of such contracts would be expected to be less than

the size of the outstanding debt as the majority of such debt will be owned byinvestors who are happy to absorb the credit risk in return for the additionalspread or risk premium. A bond hedged with CDS will, at least theoretically,generate returns close to LIBOR but with additional volatility. Long terminvestors would consider such returns to be of limited value. Howeverspeculators may profit from these differences and therefore improve marketefficiency by driving the price of bonds and CDs closer together.

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Operational Issues In Settlement

In the US, the settlement and processing of a CDS contract is currently thesubject of concern by the US Federal Reserve. In 2005, the Federal Reserveobtained a commitment by 14 major dealers to upgrade their systems andreduce the backlog of "unprocessed" CDS contracts. As of January 31, 2006,the dealers had met their commitment and achieved a 54% reduction.

In addition, growing concern over the sheer volume of CDS contractspotentially requiring physical settlement after credit events for namesactively traded in the single-name and index-trade market where the notionalvalue of CDS contracts dramatically exceeds the notional value of deliverablebonds has led to the increasing application of cash settlement auction

protocols coordinated by ISDA. Successful auction protocols have been appliedfollowing credit events in respect of Collins & Aikman, Delphi Corporation,Delta Air Lines and Northwest Airlines, Calpine Corporation, DanaCorporation, Dura Operating Corporation and Quebecor. ISDA is also using aprotocol for the settlement of contracts on Fannie Mae and Freddie Mac debt,after these entitities were placed in conservatorship.

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Loan CDS(LCDS)

The emergence of a standardized secured loan CDS (LCDS29) market is amajor development in the evolution of the loan market. Loans havehistorically been a long-only cash asset, with little or no ability forparticipants to go short risk or take on risk synthetically. LCDS allowsinvestors to take advantage of benefits and risks similar to those availableto investors in standard CDS.

These include:

The ability to implement a bullish view (sell LCDS protection) without havingto access the primary or secondary market for cash loans. The ability tocreate levered portfolios of secured risk.

The ability to hedge or implement bearish views on loans (buy LCDSprotection) and be short risk in what has traditionally been a long-onlymarket.

The ability to trade cross-asset views such as a view on the senior debtspread versus loan spread.

The ability to implement curve shape positions and views once the marketdevelops and a LCDS spread curve becomes available.

LCDS contracts are based on the standard corporate CDS contract, withseveral modifications to address the unique nature of the loan market. Wediscuss these differences, along with modifications made to LSTAdocuments, herein. Note that the actual terms of a LCDS transaction aredefined by the confirmation of that transaction only, and this research noteforms no part of that document.

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Market Participants

As in standard CDS, banks and hedge funds are the most active users ofLCDS.

Participants include:

Banks and other lenders: LCDS provides an attractive opportunity for discretehedging as an alternative to selling cash loans. LCDS also serves as analternative to proxy hedging loan exposure in the bond or standardcorporate CDS market a hedge which introduces spread correlation,recovery, basis, and other risks.

Total return funds: Total return funds can use LCDS to effectively createlevered portfolios of secured risk. We also anticipate selective positioningon spread widening or protective single-name hedging.

Structured credit vehicles: In the current market, where allocations to cashloans continue to be squeezed by excessive demand, we expect cash CLOs

to sell protection (long risk) as an alternative means to access the loanmarket. LCDS also helps CLOs avoid high dollar prices in cash loans tradingin the secondary market (high dollar prices decrease initial overcollateralization ratios), and some new structures are alreadyincorporating synthetic buckets. LCDS also provides the potential for fullysynthetic managed, bespoke, and index-tranched trades.

Structured credit investors: LCDS gives investors the ability to dynamically

hedge single loans in cash CLOs or synthetic structured credit portfolios.

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Capital Structure investors: Capital structure investors can express views onsecured loans in relation to other securities including unsecured bonds,preferred stock, or common stock. Typical trades include selling LCDSprotection (long risk) versus short a subordinate security (in cash or

derivative form) or buying LCDS protection (short risk) vs. long asubordinate security (in cash or derivative form).

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Settlement Following A Credit Event

Settlement Timing

Like in traditional CDS contracts, the protection buyer has 30 daysfollowing a credit event notice to declare their intent to settlephysically by delivering a notice of physical settlement (NOPS). TheNOPS Fixing Date is set at 3 business days after the notice ofphysical settlement is delivered. As soon as practicable after theNOPS Fixing Date, the protection buyer must deliver all necessarydocuments to effect physical settlement. Upon receipt of thesedocuments, the protection seller has 3 business days to execute andreturn the documents.

What loans are deliverable if there is a credit event?

After a credit event, loans on the secured list, or other loans thattrade as syndicated secured of equal or higher priority, aredeliverable. Term loans, revolving loans, and multi-currency loansare all deliverable.

In the case of revolvers, a seller of protection who is deliveredrevolving loans is liable for any future draws on the revolver,although in nearly all cases the ability to draw on a revolver iseliminated upon a default.

Loans trading above par after a credit event

In some cases, cash loans may trade above par after a credit event.The protection buyer, however, will not be forced to realize a loss on

the difference between par and the loan price.

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Settlement Mechanics

Like traditional CDS contracts, LCDS documents call for physicalsettlement, although (like corporate CDS) they do not precludebilateral settlement agreements or participation in any cashsettlement or netting protocols that may be developed, and weanticipate that a significant proportion of contracts will be cashsettled.

Physical settlement is governed by the documents customarily usedby the Loan Syndications and Trading Association (LSTA) that arecurrent at the notice of physical settlement fixing date, subject to

the modifications discussed in the following section of this note. Thephysical settlement process calls for settlement by:

Assignment: In an assignment, the protection seller becomes a directsignatory to the loan agreement. Assignments typically require theconsent of the borrower and agent.

Participation: If the loan cannot be transferred to the seller via

assignment due to lack of necessary consent or other failure tomeet requirements under the credit agreement, settlement mayoccur by participation. In a participation, the protection sellertakes a participating interest in the existing lenders commitment,with the protection buyer remaining the title holder of, and lenderunder, the loan.

Settlement may also occur by sub participation (the protection buyer

does not own the loan, but holds a participation from anotherparty). In this scenario, the protection seller will receive aparticipation, and will receive payments only to the extent theprotection buyer receives payment from his upstream counterparty.A protection buyer is not stepping up if he does not receivepayments from the grantor of the original participation.

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Accordingly, the protection seller is taking credit risk of more thanjust the protection buyer.

Cash Settlement: If settlement cannot be completed due to failure tomeet requirements under the credit agreement (e.g. lack ofnecessary consent), or if the seller of protection elects to cashsettle, settlement may occur by partial cash settlement. The cashsettlement amount will be the difference between 100% and theloan price as determined from dealer quotations, and cannot benegative (i.e. the buyer does not pay the seller even if the loantrades above par following a credit event).

Conclusion

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In India we have always garnered security and have always promotedFinancial instruments that not only bring about financial stability butalso have a very sound authenticity.

We always want our financial transactions should be clear and not acomplex web, which would make it difficult to achieve the financialsecurity we aim at by hedging our positions.In this regards I believe that Credit Derivatives are a boon to thefinancial markets, as they cover our risk of defaults to the maximumextent.

On the other hand I would also like to point out that if there is a Credit

Default the impact will multiply.

We have seen the adverse impact of the financial defaults in USA.

I would like to conclude my project by saying Credit Derivatives -CreditDefault Swaps are a very important hedging tool but could also have amultiplier effect in a sever Financial Default takes place.

Bibliography

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Research Reports:- Credit Derivatives Handbook 2006J. P. Morgan.

Web Sites:- www.bloomberg.bomwww.wikipedia.comwww.investopedia.comwww.isda.orgwww.bba.org.uk
http://www.bloomberg.bom/http://www.wikipedia.com/http://www.investopedia.com/http://www.isda.org/http://www.bba.org.uk/http://www.bloomberg.bom/http://www.wikipedia.com/http://www.investopedia.com/http://www.isda.org/http://www.bba.org.uk/

Documents

CDS Edited Dupe