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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:

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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

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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, &

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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, &

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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, &

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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