Credit Default Swap Final

CREDIT DEFAULT SWAPS EXECUTIVE SUMMARY
Credit risk is one of the material risks to which banks are exposed. Effective management of credit risk is, therefore, a critical factor in banks risk management processes and is essential for the long-term financial health of banks. Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures. While banks in India have developed systems and skills for identification, measurement and monitoring their credit risk exposures, the options available to them for controlling or transferring their credit risks were confined to the traditional means viz. restricting assumption of fresh exposures, outright sale of an existing fund based exposure, obtaining credit guarantee cover, obtaining credit insurance, and securitisation. While banks have been provided the options of managing their interest rate risk and foreign currency risks through the use of derivatives, similar option is not available for managing their credit risks. Credit derivatives are financial contracts designed to transfer credit risk on loans and advances, investments and other assets / exposures from one party (protection buyer) to another party (protection seller). Transfer of credit risk may be for the whole life of the underlying asset or for a shorter period. The transfer may be for the entire amount of the underlying asset or for a part of it. A credit derivative may be referenced to a single entity or to a basket of several entities. Credit derivatives may also include cash instruments (e.g. credit linkednotes) where repayment of principal is linked to the credit standing of a reference asset/ entity. This project seeks to address a study on Credit Derivatives, particularly on Credit Default Swaps in global context. The project highlights the various uses and also various controversies around the CDS market with the help of a case study. It highlights the positive and negative implications of the introduction of CDS in India and the issues that may emerge as the market gains scale. It shall also endeavor to identify issues which demand urgent attention of the regulators to ensure healthy growth of credit derivatives in India.
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CREDIT DEFAULT SWAPS Credit Derivatives: A Brief Introduction

Meaning: A credit derivative is a derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt. Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity. Why Credit Derivative? Because it has been reported that financial institutions are making substantial profits from trading credit derivatives. And at the same time there have been concerns about how well credit derivative transactions are managed. Regulators in particular have taken interest in this growing market. Anecdotal evidence would suggest that in some banks, credit derivatives constitute the main growth for traded products. And in these institutions credit transactions may account for 25%50% of trading profits. There is no doubt that for some, credit has become a major source of income, (and risk). Uses:
Credit derivatives can be used for several purposes. Here are some of their main uses: 1. Risk management & capital reduction: Credit derivatives can be used for hedging specific credit exposures, freeing up credit lines and reducing capital usage. Multiple credit exposures typically found in investment portfolios and on bank balance sheets can be hedged using collateralised debt obligations. This may lead to regulatory capital relief.
2. Investment: Credit derivatives can allow investors to increase credit exposures in order to
obtain a return for the risks they take. There are many strategies that can be adopted. Some
institutions simply sell credit protection in order to earn premium income. Credit
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CREDIT DEFAULT SWAPS

derivatives also offer relative value strategies, leveraged trades and exposures to portfolios and indices. 3. Trading: Credit trading falls into two broad categories. First there is proprietary trading this includes outright long / short strategies and relative value trades. For the proprietary trader credit derivatives offer leverage. Second there is profit to be made from supplying liquidity. The market maker gains bid-offer spreads. 4. Structured products: Credit derivative markets now offer a whole series of structured credit trades. Whilst some of these trades are complex they do one thing- they provide traders and investors with tailor made risk exposures. Whether the trades are "fair-value" is another question. 5. Miscellaneous uses: These include hedging credit spread risks before issuance, hedging receivable risks and tax arbitrage. Some of the concerns that face banks when trading credit products remain. Two issues have been highlighted by regulators: 1. How will banks deal with a large number of transactions subsequent to a credit event? 2. Can trade processing be accelerated in order to clear up outstanding transactions between counterparties? Users of credit products also need to consider what they are doing with them. In a relatively benign credit environment increasing leverage using credit derivatives will prove profitable. But in the long run this is not risk free. Only a genuine, well thought out business strategy will offer firms the best chances of success. Users of complex or structured credit products should also ask whether they fully understand the nature of the risk they are entering into. Many buyers of structured products including credit linked notes and asset backed transactions cannot accurately price or value the transactions. These products are sold on the basis of caveat emptor. Many of the valuation models rely on the user to input variables. Assumptions can cause significant errors.

Market Growth: The credit derivative market has been growing rapidly. The first transactions were initiated in the mid 1990s. In 2000 the market was estimated to be USD 0.9 trillion in size, by 2004 this figure had grown to USD 8.4 trillion. Estimates at the end of 2005 are for a market of USD 12 trillion. This growth may sound enormous but it should be put into context. The credit derivative market constitutes approximately 1% of derivative contracts traded by financial institutions Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines. The chart below shows the relative size of the credit derivatives and subprime mortgage markets.
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CREDIT DEFAULT SWAPS Assumptions and Extraordinary Personal Profits

Let's consider the simple heart of what credit derivatives are all about. A major investor has the opportunity to make an attractive-looking investment that involves taking a risk. For instance, a bank or insurance company sees an opportunity in lending to a corporation, but they are concerned about the financial safety of the corporation. They would prefer to keep most of the positive returns from the investment, but not take the risk of the company defaulting. So, as the employee of a company that creates financial derivatives (a credit swap in this case), what you do is promise - for a fee - to take the risk for them. Your company makes assumptions about how bad the risk will be, and based on those assumptions, you determine that this trade is profitable for your employer. You then personally take a nice chunk of those profits in your next bonus as a reward for having been smart enough to get your company into this lucrative transaction. And because this upfront booking of expected profits from these transactions is so lucrative, not only do you get an enhanced bonus -- but so do the other members of your group, your supervisor, their supervisor, and the president and other senior officers of the firm. Now, this is not to say that you and the other members of your group have entirely assumed the risk away. You make some allowance for the possibility that out of all these contracts that you're entering into, you may have to actually make some payments. To cover the possibility of losses, you set aside a reserve, or buy a credit derivative from another company to cover, or both. The key to your bonus this year is the particulars of the assumptions that your group makes about what those expected losses will be in the future. The lower the assumption for expected losses, then either the greater your profits in a given transaction, or the more competitive your bid, and the greater your chances of beating out competitors who are seeking the same "lucrative" business. For example, if your firm is being paid $12 million to guarantee payment of a $500 million loan for ten years, and your group assumes there is a 4% chance of having to pay out $250 million on that guarantee, then your expected losses are $10 million - and your firm's expected profit is $2 million. This is shown in the top chart below, "Making Money With Credit Derivatives".
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However, let's say that your group comes back and re-examines those assumptions. You find that if you make fairly minor and quite reasonable appearing changes to two of your assumptions, the potential loss on the derivative drops from an expected $250 million down to $225 million. Make two other minor changes in other assumptions that are also each individually reasonable, and the chances of that loss occurring drop from 4% down to 3.5%. As shown above in "Making A FORTUNE With Credit Derivatives", rerun the numbers with a 3.5% chance of losing $225 million - and your expected losses drop to $7.9 million, while your profits just doubled, going from $2 million to $4.1 million! Now, it quickly becomes clear to any reasonable person that if you can double the profits your firm recognizes on a transaction by keying in four small assumptions changes on a computer model, each of which sounds individually reasonable, and the end result of those changes is to double the bonus you get paid this year - then the key to making some serious personal money is making the right assumptions! Something that is equally plain to your peers at competitive firms.
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CREDIT DEFAULT SWAPS The Vital Role of Competition

Ah, competition! Competition is where the process starts to get interesting over time. Competition for credit derivatives business, for these easy profits, means that you and others in your company have powerful personal incentives to make aggressive assumptions about how low credit losses will be, and to validate your co-workers assumptions as well. If your assumptions are not aggressive enough, you don't win any business, you don't earn bonuses, your bosses don't earn bonuses, and you are quickly out of a job. The institutional culture then very quickly becomes that if you want to keep your job - you and the other members of your group make aggressive assumptions. If you want to make big bonuses - you make very aggressive assumptions about how low the losses will be on the credit derivatives, which then translates into increased business for you. And yes, other people will need to sign off on your group's assumptions - but they are in the same institutional culture as you are, with their own personal reward systems that are based on the company making money. Also keep in mind that even the internal (theoretical) watchdogs are put in place by senior management, who have their own incentive structure, which is based on the company making lots and lots of money this year. In a free market, where all the employees and senior management of all the financial firms want their piece of this lucrative action, the first thing that happens is that the firms with aggressive assumptions keep the firms with conservative assumptions from getting any business. And then, because we have competition going on here, in the next stage of the cycle, the very aggressive assumptions firms take the business from the merely aggressive assumption firms. Then in the next cycle, the people making the very, VERY aggressive assumptions take the business away and the bonuses away - from the merely very aggressive assumptions makers. To understand this process - you have to understand just how much money there is to be made by playing the game by its own rules, which may have very little to do with maximizing long-term shareholder value. Personal bonuses can be millions per year (with far higher payouts for hedge fund managers). As an individual who is in the right place at the right time - you can make more money in one good year than a doctor or airline pilot will make in a career. Except there is none

of this medical school, or being on call, or flying over the Pacific Ocean business involved, there's just sitting at a desk and manipulating some numbers while working the phone. As a corporation you can mint profits by the billions and tens of billions, without going through that messy business of actually building things, or selling toilet paper, or drilling for oil in two miles of ocean or such.
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CREDIT DEFAULT SWAPS Credit Default Swap: A Credit Derivative Instrument

Meaning: Credit default swaps (CDS) are the most widely used type of credit derivative and a powerful force in the world markets. A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. Credit Default Swaps can be bought by any (relatively sophisticated) investor; it is not necessary for the buyer to own the underlying credit instrument. As an example, imagine that an investor buys a CDS from CITI Bank, where the reference entity is AIG Corp. The investor will make regular payments to CITI Bank, and if AIG Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a oneoff payment from CITI Bank and the CDS contract is terminated. If the investor actually owns AIG Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing AIG Corp debt, without actually owning any AIG Corp debt. This may be done for speculative purposes, to bet against the solvency of AIG Corp in a gamble to make money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to those of AIG. If the reference entity (AIG Corp) defaults, one of two things can happen:
Either the investor delivers a defaulted asset to CITI Bank for a payment of the par value. This is known as physical settlement.
Or CITI Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if AIG Corp defaults, there is usually some recovery; i.e., not all your money will be lost.) This is known as cash settlement.
The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if

the CDS spread of AIG Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from CITI Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or AIG Corp defaults. All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can impact the comparison. The first CDS contract was introduced by JP Morgan in 1997 and by mid-2007, the value of the market had ballooned to an estimated $45 trillion, according to the International Swaps and Derivatives Association - over twice the size of the U.S. stock market. How They Work
A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event." The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the "reference entity." A contract can reference a single credit, or multiple credits.
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As mentioned above, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of the transaction, when the reference entity has a negative credit event. When such an event occurs, the party that sold the credit protection and who has assumed the credit risk may deliver either the current cash value of the referenced bonds or the actual bonds to the protection buyer, depending on the terms agreed upon at the onset of the contract. If there is no credit event, the seller of protection receives the periodic fee from the buyer, and profits if the reference entity's debt remains good through the life of the contract and no payoff takes place. However, the contract seller is taking the risk of big losses if a credit event occurs. Settlement Methodologies A CDS may specify that on occurrence of a credit event the protection buyer shall deliver the reference obligation to the protection seller, in return for which the protection seller shall pay the face value of the delivered asset to the protection buyer. This type of settlement is known as physical settlement. This settlement takes place in a CDS where the protection is bought on a specific reference obligation. It is also possible that the CDS contract may specify a number of alternative obligations of the reference entity that the protection buyer can deliver to the protection seller. These are known as deliverable obligations and this may apply in a CDS contract where the protection is bought on the reference entity instead of a specific obligation of the reference entity. Where more than one deliverable obligation is specified, the protection buyer will deliver the cheapest of the list of deliverable obligations. This is referred to as the cheapest to deliver contract. The structure of a physically settled CDS shown in Figure 1 below. This type of settlement is also known as payment of par value.
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Figure 1 : Physically Settled Credit Default Swap
A CDS may specify that on occurrence of a credit event the protection seller shall pay difference between the nominal value of the reference obligation and its market value at the time of credit event. This type of settlement is known as cash settlement. This type of settlement is also known Cash Settled Credit Default Swaps
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Documentation It is recommended that transactions in credit derivatives may be covered by the 1992 or 2002 ISDA Master Agreement and the 2003 ISDA Credit Derivatives Definitions and subsequent supplements to definitions, as amended or modified from time to time. However, banks should consult their legal advisers about adequate documentation and other legal requirements and issues concerning credit derivative contracts before engaging in any transactions. Banks should document the establishment of the legal enforceability of these contracts in all relevant jurisdictions before they undertake CDS transactions. Uses of Credit Default Swaps CDS have the following two uses.
A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract. This may be preferable to selling the security outright if the investor wants to reduce exposure and not eliminate it, avoid taking a tax hit, or just eliminate exposure for a certain period of time.
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The second use is for speculators to "place their bets" about the credit quality of a particular reference entity. With the value of the CDS market, larger than the bonds and loans that the contracts reference, it is obvious that speculation has grown to be the most common function for a CDS contract. CDS provide a very efficient way to take a view on the credit of a reference entity. An investor with a positive view on the credit quality of a company can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on the company's bonds. An investor with a negative view of the company's credit can buy protection for a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has some other credit event. A CDS can also serve as a way to access maturity exposures that would otherwise be unavailable, access credit risk when the supply of bonds is limited, or invest in foreign credits without currency risk.
An investor can actually replicate the exposure of a bond or portfolio of bonds using CDS. This can be very helpful in a situation where one or several bonds are difficult to obtain in the open market. Using a portfolio of CDS contracts, an investor can create a synthetic portfolio of bonds that has the same credit exposure and payoffs.
Criticisms of CDS
Warren Buffet famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaways annual report to shareholders in 2002, he said "Unless derivatives contracts are collateralized 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 much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." The same report, however, also states that he uses derivatives to hedge, and that some of Berkshire Hathaway's subsidiaries have sold and currently sell derivatives with 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 vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10

billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives, in this case, also amplify it considerably. This will happen when the CDS have been made for purely speculative purposes; if the CDS were being used to hedge, the notional values would be approximately the same size as the outstanding debt. However, for informed investors, CDS premiums can act as a good barometer of company's health. If investors are not sure about a firm's credit quality they will demand protection thus pushing up CDS spreads on that name in the market. Equity markets will then draw a cue from the credit markets and push down the stock price based on fear of corporate default.
Trading
While most of the discussion has been focused on holding a CDS contract to expiration, these contracts are regularly traded. The value of a contract fluctuates based on the increasing or decreasing probability that a reference entity will have a credit event. Increased probability of such an event would make the contract worth more for the buyer of protection, and worth less for the seller. The opposite occurs if the probability of a credit event decreases. A trader in the market might speculate that the credit quality of a reference entity will deteriorate some time in the future and will buy protection for the very short term in the hope of profiting from the transaction. An investor can exit a contract by selling his or her interest to another party, offsetting the contract by entering another contract on the other side with another party, or offsetting the terms with the original counterparty. Because CDSs are traded over the counter (OTC), involve intricate knowledge of the market and the underlying assets and are valued using industry computer programs, they are better suited for institutional rather than retail investors.
Risks involved:
When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk. Examples of counter party risks:
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The buyer takes the risk that the seller will also default. That is, if Risky Corp. defaults on the reference obligation, Derivative Bank will not pay off the CDS.
The seller takes a risk that the buyer will drop out of the contract, depriving the seller of the expected revenue stream. Also, a seller would normally limit its risk by buying partial protection from another party at a lower price - a form of reinsurance. If the original buyer drops out, the seller must still pay for its reinsurance, becoming de facto long the risk in the reference obligation. The seller would usually seek to square its position by selling a new CDS to a third party. But that may be at a lower price than the original CDS, depending on market conditions.
A form of liquidity risk may be created with a CDS contract. If one or both parties to a CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional collateral. The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating of one of the parties changes. CDS also observes market risk. The market for CDSs is OTC and unregulated, and the contracts often get traded so much that it is hard to know who stands at each end of a transaction. There is the possibility that the risk buyer may not have the financial strength to abide by the contract's provisions, making it difficult to value the contracts. The leverage involved in many CDS transactions, and the possibility that a widespread downturn in the market could cause massive defaults and challenge the ability of risk buyers to pay their obligations, adds to the uncertainty.
Regulatory concerns over CDS

A number of large scale incidents occurring in 2008 drew considerable attention onto the CDS. In the days and weeks leading up to the collapse of Bear Stearns, the bank's CDS spread widened dramatically, indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital which eventually led to its forced sale to JP Morgan in March. An alternative view is that this surge in CDS protection buyers was a
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symptom rather than a cause of Bear's collapse; i.e. investors saw that Bear was in trouble, and sought to hedge any naked exposure to the bank, or speculate on its collapse. In September the bankruptcy of Lehman Brothers caused a total close to $400 Billion to become payable to the buyers of CDS protection referenced against the insolvent bank. However the net amount that changed hands was around $7.2 billion. This difference is due to the process of 'netting'. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral so their losses and gains after big events will on the whole offset each other. Also in September American International Group (AIG) required a federal bailout because it had been excessively selling CDS protection without hedging against the possibility that the reference entities might decline in value, which exposed the insurance giant to potential losses over $100 Billion. While the CDS on Lehman were settled smoothly, and its arguable that other incidents would have been as bad or worse if less efficient instruments than CDS had been used for speculation and insurance purposes, the closing months of 2008 saw regulators working hard to reduce the risk involved in CDS transactions. In 2008 there was no centralized exchange or clearing house for CDS transactions; they were all done over the counter (OTC). This led to recent calls for the market to open up in terms of transparency and regulation . In November, DTCC, which runs a warehouse for CDS trade confirmations accounting for around 90% of the total market[16], announced that it will release market data on the outstanding notional of CDS trades on a weekly basis. The data can be accessed on the DTCC's website here: The U.S. Securities and Exchange Commission granted an exemption for IntercontinentalExchange to begin guaranteeing credit-default swaps. The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental. Its larger competitor, CME Group Inc., hasnt received an SEC exemption, and agency spokesman John Nester said he didnt know when a decision would be made.
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CREDIT DEFAULT SWAPS Valuation of credit default swap (CDS)

The key to understanding valuation of a credit default swap (CDS) is to realize that we are solving for the unknown spread (given by s) that calibrates an equality: the present value (PV) of the expected payments made by the CDS buyer should equal the PV of the expected payoff received by the CDS buyer (i.e., the contingency payoff made by the CDS seller in the event of a default). The payments are like insurance premiums; the payoff is like an insurance claim. The CDS buyer should expect a fair deal, on a probability-adjusted, and present-value, basis. The question I often get is, why are there two terms on the payments side? In the diagram below, on the left we have the payments made by the CDS buyer; on the right, the payoff received (i.e., contingent payment by CDS seller in the event of default). Remember that we are not only present valuing the payments, but we are weighting by the probability of their occurrence. So on the left, we have a series of five annual end-of-year payments that are highly likely to be made (1 minus probability of default) ^ nth year). But, if there is a default on the eighteenth month, the CDS buyer will owe an accrued six month payment (i.e., she paid the first year but hasnt paid for the second year, yet). Note this is largely a function of the models simplistic assumption that defaults occur only mid-year. That is why there are two terms on the payment side: we need to add the highly likely payments to the highly unlikely accrual payments (in the event of default). The right side is easier: the highly unlikely payoffs are simply summed. (by the way, we can sum them because they are mutually exclusive. It is not redundant. For example, the odds of a payoff on the year 2.5 are a joint probability that equals the odds of "surviving" for two years multiplied by the odds of "not surviving" the third year. These probabilities are additive).
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So the example in my FRM movie assumes a notional of $1 million, a riskless rate of 5%, a probability of default (PD) of 3% and a recover rate of 60%:
The payment (or left-hand side above) then looks like this:
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And the payoff (or right-hand side above) looks like this:
And setting them equal implies that 3.953s + 0.063s = 0.05s, which means that s equals about (almost) 0.0125. That is the spread that makes the PV(payments) equal to the PV (payoff). This is how the valuation of a CDS contract works.
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CREDIT DEFAULT SWAPS IS INDIA READY FOR CREDIT DEFAULT SWAPS ?

With India having grown at an average of 8.6% in the past 4 years, there has been an excessive demand for capital from all sorts of businesses to further fuel their growth. Banks seek to address this need for capital and in turn assume risk. But for India to continue to grow at over 9% its an imperative that we have healthy financial institutions which are able to manage their risks well. Credit derivatives which emerged globally nearly a decade ago and created a rage as effective tools for credit risk management are set to make their debut in India to help banks better manage their credit risks. The RBI recently released the Draft Guidelines on Credit Default Swaps, as a small first step towards creating an onshore credit derivatives market. The guidelines aim to introduce CDS in a calibrated manner in India and are reflective of a conservative approach adopted by the RBI. The conservatism possibly stems from the inexperience of the Indian markets with such products, but could in-part also be attributed to derivatives being viewed as financial weapons of mass destruction. The role credit derivatives had to play in the recent Sub-prime crisis does to an extent validate the adopted approach. The guidelines regulate credit derivative transactions by Indian resident commercial banks & primary dealers. Currently only 'plain vanilla' credit default swaps (CDS) have been permitted. The guidelines limit CDS trades to transactions referenced to single, rated, resident entities only, with both the protection buyers (PB) and protection sellers (PS) being resident. The PB must be in a position to identify a specific credit exposure which it is hedging, and this exposure may have to be referenced in the CDS. The reference obligation and, if different, the deliverable obligation must be rated and denominated in Indian Rupees. Related party transactions have been disallowed and the CDS must be denominated and settled in Indian rupees.
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The table below indicates that Single-name CDS are the fastest growing segment of credit derivatives globally.
( in Percentages ) Type Basket Products Credit Linked Notes Credit Spread Options Equity linked Credit Products Full Index Trades 2000 6 10 5 n/a n/a 2002 6 8 5 n/a n/a 2004 4 6 2 1 9 2006 1.8 3.1 1.3 0.4 30.1
Single - name Credit Default Swaps 38 Swaptions Synthetic CDO's - Full Capital Synthetic CDO's - Partial Capital Tranched Index Trades Others n/a n/a n/a n/a 41
45 n/a n/a n/a n/a 36
51 1 6 10 2 8
32.9 0.8 3.7 12.6 7.6 5.7
The rather disheartening feature of the guidelines is that banks are allowed to use CDS but only for hedging purposes. Globally, credit derivatives are being used not only for hedging purposes but also for creating exposures to certain assets. This policy measure also deprives the credit derivatives market of the much needed liquidity extended by the presence of speculators/arbitragers. The guidelines stipulate that the CDS contract shall not have a materiality threshold and this shall help further reduce the credit exposure of banks. The guidelines require that the reference obligation be identical with the underlying exposure and this may be rather impossible to achieve practically.
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CREDIT DEFAULT SWAPS Positive Implications of the Introduction of CDS

Buoyancy in the Indian economy in the recent past has led to corporates drawing up aggressive expansion plans requiring large amounts of capital for long tenors. Due to a multiplicity of issues, Indian banks/debt-markets have not been able to feed the hunger for capital of these corporates, forcing them to look overseas. Even infrastructure/projectfinancing in India is plagued by similar issues, as also the lack of project appraisal skills for these highly levered projects. Inability to hedge the credit risk and the illiquidity of assets has prevented banks from financing such projects resulting in loss of potential business. A vibrant/deep/liquid credit derivatives market could allow the banks to retain these assets on their balance sheets even while they are relieved of the credit risk, thus prompting banks to finance such projects. The introduction of BASEL-II norms post 2008, which attach a risk weightage commensurate with the credit ratings, is expected to put pressure on banks to allocate capital towards CAR purposes. The availability of CDS would help in the reduction of capital required to be allocated towards Capital Adequacy purposes thereby freeing up capital for other needs. This would be of great interest particularly to PSBs (especially those planning to set up capital intensive insurance ventures), constrained by a compulsory 51% government holding, thereby stunting their ability to raise fresh capital to fuel growth.
The current shortfall in banking capital is estimated between $6 billion and $8 shortfall will grow as banks try to step up their lending to a booming economy. Source: Businessworld
billion. And the
RBI statistics suggest that the NPA % in non-priority advances is higher for all bank groups than that for priority sector advances, even while overall NPA levels are declining. In the current booming Indian economy NPA levels cease to be a cause of concern, but in a sluggish economy they may rise and be a cause of grave concern. CDS would provide banks with the ability to churn their portfolios, stem the rise in NPAs and also help free up regulatory capital. They would ensure diversification of risks amongst
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numerous investors, thereby reducing the impact on a single banking entity, attributing in part to its sustained competitiveness. Earlier securitization was the only option available to banks for managing their credit risks. But now banks averse to securitization due to the costs/legal/tax/regulatory reasons could resort to usage of CDS for credit risk management. CDS could also be used by banks to hedge their exposure to select corporate entities. This is a crucial advantage as short-selling of corporate debt is currently impermissible. CDS spreads could be used as an indicator to assess the risk profile of debt in a well developed corporate debt-market. Arbitrage opportunities might also exist when the purchase of a risky bond along with the appropriate CDS may provide a better yield than the equivalent risk free instrument. With trading/issuance in the Indian debt-market currently limited only to investment grade paper, the introduction of CDS may help in extension of trading/issuance activity to lower rated paper imparting greater vibrancy to the market. But the current lack of interest in reviving the Indian debt-markets may continue to constrain such positive trickle down effects of the use of CDS. With the availability of better credit risk management tools, the regulators could consider relaxing the norms requiring provident/pension funds to invest only up-to 10% of the accruals in a year in private corporate bonds and a maximum of 40% of the corpus to be invested in bonds issued by public sector undertakings. This would help improve the returns these funds generate and also add liquidity to the market.
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CREDIT DEFAULT SWAPS Negative Implications of the Introduction of CDS

While CDS may ensure the transfer of credit risk to the counter-party to the transaction it in no way protects the PB from the risk of default of the PS. Counter- party risk is a cause of great concern particularly in a recessionary environment where the occurrence of a large number of credit-events could threaten the financial viability of the counter-party. This is of even greater relevance in India as initially only the few large banks are expected to emerge as the PS thus leading to concentration of risk. The sharing/diversification of risks through the use of CDS may lead to a false perception of the asset quality in the minds of the investors and thus result in inflated asset prices. The inevitable but highly undesirable outcome of credit derivatives is the reduced emphasis on credit monitoring due to the sharing of credit risks. With the comfort of credit risk protection at hand banks may also succumb to the tendency of lending to riskier projects. Had the introduction of CDS not been restricted to usage for hedging purposes, they could have throw up opportunities for regulatory arbitrage. In cases where regulations disallow banks from taking positions in certain corporate assets, banks may build an exposure through such derivatives. Thus though not a drawback in the current context, regulatory arbitrage extended by CDS may become a cause of concern as and when RBI decides to extend the usage to trading purposes. A prime reason for the moribund state of Indian debt-markets is the requirement to markto-market the bond portfolio, whereas for loans such a requirement does not exist, thereby resulting in banks preferring to extend loans. By the very same logic the a negative implication of the proposed guidelines which require that the CDS portfolio be marked-to-market, is that it may serve as a disincentive for banks keen on window dressing their balance sheets. This mindset of the Indian banking system may come to haunt the credit derivatives market just as it has haunted the corporate debt- market. In keeping with the conservative approach adopted by the RBI, the choice of binary settlement should have been avoided. Market inexperience which has been cited as a reason for the calibrated introduction of CDS shall also play spoil sport in determining accurately the fixed recovery to be agreed upon incase of binary settlement and thus

provide an inadequate hedge. In India Certificate-of-Deposits (CD) & Commercial-Paper (CP) with a maximum maturity of one year are very popular means of raising short term finances, especially in the face of immense interest rate volatility. RBI guidelines which have limited the minimum maturity of CDS to 1 year would prevent banks from hedging their credit exposure towards such forms of corporate debt. Absence of this restriction would have also aided the growth of lower rated CP/CD issuance which would add greater depth at the shorter end of the yield-curve.
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CREDIT DEFAULT SWAPS Issues Demanding Urgent Attention

Revival of the listless corporate debt-markets in India is of prime importance. A vibrant credit derivatives market cannot exist in the absence of a healthy corporate bond yieldcurve. A thriving corporate debt-market will provide the PS with an opportunity to further hedge the credit protection extended by them and in turn shall provide tremendous impetus to the credit derivatives market. It is imperative that prompt action is taken on the recommendations of the R.H.Patil committee report to improve participation in the debt-markets as illiquidity could result in inefficient pricing as a consequence of lackadaisical trading activity. Rating agencies have in the past faced flak for failing to provide any advance warning of impending crisis like the East-Asian crisis, Enron/WorldCom fiascos, Sub-prime crisis, etc. Mindful of the imperative role that credit rating agencies have to play in the development of credit derivatives market, its essential that such agencies develop robust risk assessment protocols/rating migration mechanisms. Cost efficacy of the intensive rating process for complex structures also needs to be ensured by the agencies. As already mentioned loans are far more popular in India currently, rather than bonds, both with corporate borrowers and banks. With the proportion of lending to borrowers with no/ low ratings set to increase, its a need of the hour for the RBI to clarify whether loans qualify for the rupee denominated CDS. Failure of loans to qualify for the same would greatly cripple the ability of banks to transfer a substantial amount of credit risk that exists on their balance sheets due to the massive loan portfolios.
Indian banks hold 17.9 trillion rupees in all loans. Outstanding Indian corporate debt is estimated at 535 billion rupees. Source: CMIE & NSE
Even while India has robust trade settlement & clearing mechanisms, if the growth in the CDS market globally is to be replicated in India as well, there should be greater thrust on the development of efficient and time/cost-effective clearing and settling mechanisms for
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the trades. In the aftermath of a credit-event the existing system may crumble under the tremendous load of physical/cash settlement of actively traded names. There is also a need for aiding the consolidation of the Indian banking industry. This would help in the emergence of a few large banks whose balance sheets would allow them to serve as counter-party to larger/riskier assets. Its crucial that Mutual funds, Insurance companies and Pension funds be granted permission by SEBI/IRDA/PFRDA to participate in these markets. Mutual/Insurance/ Pension funds have witnessed an exponential rise in AUM in the recent past and are thus capable of bringing immense liquidity and depth to the market. Insurance/ Pension funds are particularly focused on the longer end of the curve and hold long bond positions as a result of which they are adept at being PS. Such investors will greatly address the lack of a sell side.
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The guidelines require the PS/PB to be resident entities. But allowing offshore PS may also in some small measure help deal with the tremendous forex inflows that India is currently faced with. The inflows (as a result of credit-events) from these offshore PS could have significantly positive implications in a scenario where the macroeconomic environment triggers a downturn and a flight of capital from the country. By virtue of prior experience they would be better adept at assessing the risk and pricing it efficiently. But allowing offshore PS could negatively impact the development of the domestic market and thus the pros and cons need to be carefully weighed against each other.
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CREDIT DEFAULT SWAPS Guidelines Issued By RBI on CDS

PRUDENTIAL NORMS 4.1 Eligible counterparties
4.1.1 RBI has been allowing transactions between the banks and their financial services subsidiaries on the principle of arms' length relationship i.e., the transactions should be on the basis of market related rates and based on free availability of information to both the parties. As the credit derivative market in India will take some time to develop, it would be difficult to have an objective and transparent price discovery mechanism at this stage and, therefore, difficult to determine whether an arms' length relationship exits or not. Therefore, banks are not permitted to enter into credit derivative transactions where their related parties are the counterparties or where the related parties are reference entities. 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 group entity. 4.2 Classification - trading book & banking book
4.2.1 Credit derivatives qualify as a financial derivative and hence shall be included in the trading book unless (a) it is designated as a hedge of a credit risk exposure in the banking book at the time of entering into the derivative transaction; and (b) it is satisfying the hedge effectiveness criterion. 4.3 Applicability of guarantee norms
4.3.1 A CDS contract will not be deemed to be a guarantee and will consequently not be governed by the regulations applicable to bank guarantees. This is because CDS contracts are normally concluded under standardized master agreements, they are structurally different from bank guarantees, they may have a secondary market and they are regulated under these special regulations.
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4.4
Amount of protection under CDS
4.4.1 Amount of credit protection: The credit event payment or settlement amount will determine the amount of credit protection bought /sold in case of CDS. The amount of credit protection shall be the amount that the protection seller has undertaken to pay in the event of occurrence of a credit event specified in the CDS contract without netting the value of the reference asset. 4.4.2 Amount of risk assumed when protection is sold: When a bank has sold credit protection using a credit derivative, it should be assumed that the protection seller has assumed credit risk on 100 per cent of the amount of protection (as defined in paragraph 4.4.1) irrespective of the credit events specified or mismatches if any between the underlying asset/ obligation and the reference / deliverable asset / obligation with regard to asset or maturity. 4.5 Capital Adequacy for Protection Seller 4.5.1 Where a Protection Seller has sold protection through a CDS it acquires exposure to the credit risk of the deliverable asset/ reference asset to the extent of the amount of protection computed as per paragraph 4.4. This exposure should be risk-weighted according to the risk weight of the reference entity or reference asset, whichever is higher. Sold CDS will be an off balance sheet item with a CCF of 100%. 4.5.2 The protection seller will also have an exposure on the protection buyer as a long position in a series of zero coupon bonds issued by the protection buyer (representing the periodic payment of premium). 4.5.3 Banks are not permitted to have a position as protection buyer in their banking book except as a hedge against a credit risk exposure. In such case the capital adequacy treatment will be as detailed in paragraph 5.6 below.
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4.6 Capital adequacy for Credit Derivatives in the Trading Book 4.6.1 Recognition of positions: The general norms for recognising positions by the participants dealing in CDS are as under: 1.A credit default swap does not normally create a position for general market risk. 2.A CDS creates a notional long or short position for specific risk in the reference asset/ obligation. The notional amount of the CDS must be used and the maturity of the CDS contract will be used instead of the maturity of the reference asset/ obligation. 3. The premium payable / receivable create notional positions in government securities of relevant maturity with the appropriate fixed or floating rate. These positions will attract appropriate capital charge for general market risk.
4. A CDS contract creates a counterparty exposure on the protection seller on account of the credit event payment and on the protection buyer on account of the amount of premium payable under the contract. 4.6.2 Banks may fully offset the specific risk capital charges when the values of two legs (i.e., long and short) always move in the opposite direction and broadly to the same extent. This would be the case when the two legs consist of completely identical instruments - including the identity of the reference entity, maturity, and coupon; - there is an exact match between the maturity of both the reference obligation and the credit derivative, and the currency of the underlying exposure; the credit events are identical (including their definitions and settlement mechanisms).In these cases, no specific risk capital requirement applies to both sides of the position. 4.6.3 Banks may offset 80% of the specific risk capital charges when the value of two legs (i.e. long and short) always moves in the opposite direction but not broadly to the same extent. This would be the case when a long cash position is hedged by a credit default swap (or vice versa) and there is an exact match in terms of the reference obligation, and the maturity of both the

reference obligation and the credit derivative. In addition, key features of the credit derivative contract (e.g. credit event definitions, settlement mechanisms) should not cause the price movement of the credit derivative to materially deviate from the price movements of the cash position. To the extent that the transaction transfers risk, an 80% specific risk offset will be applied to the side of the transaction with the higher capital charge, while the specific risk requirement on the other side will be zero. 4.6.4 Banks may offset partially the specific risk capital charges when the value of the two legs (i.e. long and short) usually moves in the opposite direction. This would be the case in the following situations: The position is captured in paragraph 4.6.2 or paragraph 4.6.3 but there is a maturity mismatch between the credit protection and the underlying asset. The position is captured in paragraph 4.6.3 but there is an asset mismatch between the cash position and the credit derivative. However, the underlying asset is included in the (deliverable) obligations in the credit derivative documentation. In these cases rather than adding the specific risk capital requirements for each side of the transaction (i.e. the credit protection and the underlying asset) only the higher of the two capital requirements will apply. 4.6.5 In cases not captured in paragraphs 4.6.2 to 4.6.4, a specific risk capital charge will be assessed against both sides of the position, without any offsets. Protection Seller: 1.The protection seller in a credit-default swap should enter into the maturity ladder a long position in a notional government debt instrument with appropriate fixed or floating rate, where regular fee/ premia cash flows are to be received, to reflect the general market risk associated with those cash flows. 2. A specific risk capital charge must also be calculated on the long position in the reference entity (reference asset/ obligation).
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3. The protection seller should compute the counterparty capital charge using the current exposure method if fee/ premia payments are outstanding. While computing the current exposure on the counterparty for transactions in the trading book the potential future exposure add-on factor of 10% should be applied. For contracts with multiple exchange of principal, the factor is to be multiplied by the number of remaining payments in the contract. The protection seller shall apply the add-on factor if it is subject to closeout upon the insolvency of the protection buyer while the underlying is still solvent. In this case, the add-on should be capped to the amount of unpaid premia. 4.6.7 Protection buyer: 1. The protection buyer in a credit-default swap should enter into the maturity ladder a short position in a notional government debt instrument with appropriate fixed or floating rate, where regular fee/ premia cash flows are to be paid, to reflect the general market risk associated with those cash flows. 2. A specific risk capital charge must also be calculated on a short position in the reference entity (reference asset/ obligation). 3. The protection buyer in a CDS contract relies on the protection seller to pay the credit event payment if a credit event occurs, and therefore, should recognise a counterparty risk exposure on the protection seller. The protection buyer should compute the counterparty capital charge using the current exposure method. While computing the current exposure on the counterparty for transactions in the trading book the potential future exposure add-on factor of 10% should be applied. For contracts with multiple exchange of principal, the factor is to be multiplied by the number of remaining payments in the contract. 4.7 Exposure Norms 4.7.1 Protection buyer: While computing its credit exposure to a reference entity, the protection buyer (a) may set off the exposure to the reference entity; and (b) shall reckon this exposure (which is non-fund based) on the protection seller to the extent of credit protection purchased through a CDS contract where there is no maturity mismatch. Where there is a

maturity mismatch, and the time to expiry of CDS is three months or less,credit derivatives do not reduce the credit exposure to the underlying asset/ reference entity and, therefore, the protection buyer shall start reckoning exposure on the underlying asset/ obligor when
residual period left is less than three months. 4.7.2 Protection Seller: Conversely, while computing its credit exposure to a reference entity, the protection seller shall add to the existing exposure (if any) on the reference entity, the extent of credit protection sold through a CDS contract, as a non-fund based exposure on the reference entity. In addition, the protection seller shall reckon an off-balance sheet credit exposure on the protection buyer to the extent of the premia receivable periodically over the term of the credit derivative contract. 4.7.3 Once the aggregate credit exposure on the reference entity or the protection seller or the protection buyer, including credit derivative contracts, is computed, banks will have to ensure that they are compliant with the prudential credit exposure limits (the lower of regulatory and internal limits) applicable to the reference entities/ protection sellers. In case the reference entity is a commercial bank or a co-operative bank, compliance with the internal limits set for each of those counterparties should be complied with. For the purpose of these guidelines 1. The participants which are not subjected to a regulatory limit on their counterparty credit risk exposures similar to commercial banks but are subject to regulatory capital adequacy requirement, shall observe a counterparty exposure limit of 15 per cent of their capital funds or the counterparty exposure limits as stipulated by their regulator, whichever is less; 2. Exposure will include both fund based and non-fund based exposures; 3. Exposure shall be reckoned as limits or outstanding whichever is higher; 4. Participants which do not have a capital adequacy requirement similar to commercial banks shall compute their counterparty exposure limits as 15 percent of their net worth. These entities will compute net worth as paid up capital + reserves - revaluation reserves - accumulated losses - intangible assets - goodwill (if any)
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CREDIT DEFAULT SWAPS Provisioning Requirements

4.8.1 Protection Buyer: The underlying asset in respect of which the protection buyer has bought credit risk protection will continue to be on the protection buyers balance sheet. Consequently, the protection buyer shall hold adequate provision for standard assets until the occurrence of a credit event. 4.8.2 Protection Seller: The protection seller is not assuming a fund based credit exposure on the reference entity/ underlying asset and hence, it may not hold provisions for standard assets until the occurrence of the credit event and the deliverable obligation. 4.9 Prudential treatment post credit event 4.9.1 Protection buyer: From the date of credit event and until receipt of credit event payment in accordance with the CDS contract, the protection buyer shall ignore the credit protection of the CDS and reckon the credit exposure on the underlying asset/ reference entity and maintain appropriate level of capital and provisions as warranted for the exposure. On receipt of the credit event payment, (a) the underlying asset shall be removed from the books if it has been delivered to the protection seller or (b) the book value of the underlying asset shall be reduced to the extent of credit event payment if the credit event payment does not fully cover the book value of the underlying asset and appropriate provisions shall be maintained for the reduced value. 4.9.2 Protection seller: From the date of credit event and until making of the credit event payment in accordance with the CDS contract, the protection seller shall debit the profit and loss account and recognize a liability to pay to the protection buyer, for an amount equal to the amount of credit protection sold. After the credit event payment, the protection seller shall recognize the assets received, if any, from the protection buyer at the assessed realizable value and reverse the provisions made earlier, up to that amount. Thereafter, the protection seller shall subject these assets to the appropriate prudential treatment as applicable to loans and advances or investments, as the case may be.
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CREDIT DEFAULT SWAPS 5. USE OF CREDIT DEFAULT SWAPS AS A CREDIT RISK MITIGANT
Use of CDS for hedging by banks 5.1 Banks can use CDS contracts to hedge against the existing credit risk in their portfolios, both on balance sheet and off balance sheet. CDS contracts will be recognized as credit risk mitigants if they fulfill the criteria outlined in this section. The extent to which credit risk mitigation is recognized is also detailed below. 5.2 The reference asset/ obligation shall (a) Have seniority equal to or senior to; and (b) Have maturity equal to or longer than the underlying obligation. 5.3 Since a materiality threshold may affect the amount of protection that is recognized, the amount of protection recognized will be reduced by the materiality threshold. 5.4 The credit derivative should conform to the following general criteria to be recognized as a credit risk mitigant: i) A CDS contract must represent a direct claim on the protection seller and must be explicitly referenced to specific exposures of the protection buyer, so that the extent of the cover is clearly defined and incontrovertible. The contract must be irrevocable; there must be no clause in the contract that would allow the protection seller unilaterally to cancel the cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the underlying asset / obligation. ii) The CDS contract shall not have any clause that could 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. iii) The protection seller shall have no recourse to the protection buyer for losses. iv)The credit events specified in the CDS contract shall contain as wide a range of triggers as
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possible with a view to adequately cover the credit risk in the underlying / reference asset and, at a minimum, cover the following. (If the set of credit events is restrictive, it is possible that the credit derivative will transfer insufficient risk.) Failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation); Bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; Restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account); and
v) CDS contracts must have a clearly specified period for obtaining post-creditevent valuations of the reference asset, generally no more than 30 days; vi)The credit protection must be legally enforceable in all relevant jurisdictions; vii) The reference / obligation shall have equal seniority with, or greater seniority than, the underlying asset/ obligation, and legally effective crossreference clauses (e.g. cross-default or
cross-acceleration clauses) should be there between reference asset and the underlying assets. viii) The protection buyer must have to the the right/ability seller, to if transfer required the for
reference/deliverable settlement;
asset/
obligation
protection
ix) The credit risk transfer should not contravene any terms and conditions relating to the reference / deliverable / underlying asset/ obligation and where necessary all consents should have been obtained. x) If the reference obligation in a credit derivative does not include the underlying obligation, sub-paragraph (xiii) below governs whether the asset mismatch is permissible.

xi) The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay. If it does, it will be considered as maturity mismatch and treated as detailed below. xii) The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection seller of the occurrence of a credit event; xiii) Where there is an asset mismatch between the underlying asset/ obligation and the reference asset/ obligation then: The reference and underlying assets/ obligations must be issued by the same obligor (i.e. the same legal entity); The reference asset must rank pari passu or senior to the underlying asset/ obligation;
5.5 Recognition of amount of protection bought: When a bank has bought protection, the amount of credit protection (as defined in paragraph 4.4.1) shall be adjusted if there are any mismatches between the underlying asset/obligation and the reference/deliverable asset /obligation with regard to asset or maturity. These are dealt with in detail in the following paragraphs. Asset mismatches: Asset mismatch will arise if the underlying asset is different from the reference asset or deliverable obligation. Protection will be reckoned as available by the protection buyer only if the mismatched assets meet the requirements specified in paragraph 5.4 (xiii) above. 5.5.2 Maturity mismatches: The protection buyer would be eligible to reckon the amount of protection if the maturity of the credit derivative contract were to be equal or more than the maturity of the underlying asset. If, however, the maturity of the credit derivative contract is less than the maturity of the underlying asset, then it would be construed as a maturity mismatch. In case of maturity mismatch the amount of protection will be determined in the following manner.
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i) If the residual maturity of the credit derivative product is less than three months no protection will be recognized. ii) If the residual maturity of the credit derivative contract is three months or more protection proportional to the period for which it is available will be recognized. When there is a maturity mismatch the following adjustment will be applied. Pa = P x (t- .25) (T- .25) Where: Pa= value of the credit protection adjusted for maturity mismatch P = credit protection (as per paragraph 4.4.1) adjusted for any haircuts t = min (T, residual maturity of the credit protection arrangement) expressed in years T = min (5, residual maturity of the underlying exposure) expressed in years Example: Suppose the underlying asset is a loan of Rs. 100 to a corporate where the residual maturity of 5 years and the residual maturity of the CDS is 4 years, the amount of credit protection is computed as under: 100 * {(4-.25) (5-.25)} = 100*(3.75 4.75) = 78.95 iii) Once the residual maturity of the credit derivative contract reaches three
months, protection ceases to be recognized.
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6 ACCOUNTING ASPECTS 6.1 Issues related to Accounting 6.1.1 Normal accounting entries for credit derivative transactions are fairly straightforward depending on cash flows that take place at various points in time during the tenor of the transaction. e.g. for a credit default swap, there will be periodic payment of fees by the protection buyer to the protection seller. If there is a credit event, then settlement will be appropriately accounted depending on whether cash settled or settled via physical exchange versus par payment. 6.1.2 The accounting norms applicable to credit derivative contracts shall be on the lines indicated in the Accounting Standard (AS) 30-Financial Instruments: Recognition and Measurement, approved by the Institute of Chartered Accountants of India. 6.1.3 Banks may adopt appropriate norms for accounting of Credit Default Swaps which are in compliance with the guidelines issued by the Reserve Bank from time to time, with the approval of their respective boards. 6.1.4 Mark to market: The CDS contracts allowing for cash settlement are recognized for capital purposes insofar as a robust valuation process is in place to estimate loss reliably. Banks need to put in place appropriate and robust methodologies for marking to market the CDS contracts as also to assess the hedge effectiveness, where applicable. These methodologies should also be subject to appropriate internal control and audit.
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7 SUPERVISORY REPORTING 7.1 Banks shall report the details as per the proforma in paragraph 7 below, to the Department of Banking Supervision along with their periodical DSB returns. The supervisory reporting shall be made on a monthly basis. 7.2 All banks shall report the details of their CDS transactions on a fortnightly basis within a week after the end of the fortnight as per the proforma furnished in the Appendix, to the Department of Banking Supervision. 7.3 On the basis of the stage of development of the credit derivative market in India, the supervisory reporting requirements will be reviewed and may be revised to capture greater details. Conclusion with respect to the guidelines The proposed introduction of CDS is part of the larger objective of developing the domestic corporate debt-market. Such a market will help the transfer of risk from risk- averse players to those who are best able to manage and carry an appetite for the risk. We must be prepared to accept that the market for this product will develop slowly in India. The foreign banks, new private sector banks and a few primary dealers are likely to be the players initially followed by the entry of progressive public sector banks. Whilst there is sufficient vibrancy/depth in the buy side in the Indian context, the regulators need to primarily focus on aiding the development of a vibrant sell side. They also need to ensure that all enabling/supporting bodies like credit rating agencies, clearing & trade settlement organizations, etc are well equipped to cater to the needs of this new market. As the market develops the regulators also need to progressively lower the restrictions currently applicable so that the market can charter its growth trajectory independently. The regulators should aim at providing sufficient headroom for innovation in financial products/services while at the same time ensuring that this innovation does not expose the economy to undue risk.
Positive Implications of the Introduction of CDS
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Positive Implications of the FALLING GIANT: A CASE STUDY OF AIG
A CASE STUDY
"The biggest fears had to do with the credit-default swaps, which AIG appears to have sold in large quantities to practically every financial institution of significance on the planet. RBC Capital Markets analyst Hank Calenti estimated Tuesday that AIG's failure would cost its swap counterparties $180 billion.
"Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression," wrote money manager Michael Lewitt in Tuesday morning's New York Times." - Time, September 17, 2008
"'I am floored,' said former Treasury counsel Peter Wallison in an interview. 'No one could have possibly imagined this a few months ago.'" - Bloomberg, September 17, 2008 Overview While it may look superficially similar to the recent implosions of such investment giants as Fannie Mae, Freddie Mac and Lehman, the takeover and bailout of AIG is quite different, and means that the market is entering the next and even more dangerous phase. What is driving the fall of AIG - and potential government losses that may far, far exceed the $85 billion bailout announced late on September 16th - is not mortgages or real estate (directly), but fears that AIG's huge, global credit-default swap positions will unravel. The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.
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The Rapid & Dangerous Collapse of AIG "The particular risks that brought the company (AIG) to the brink of bankruptcy seem to lie not with its core insurance businesses but with its derivatives-trading subsidiary AIG Financial Products. AIG FP, as it's called, merits a mere paragraph in the nine-page description of the company's businesses in its most recent annual report. But it's a huge player in the new and mysterious business of credit-default swaps: derivative securities that allow banks, hedge funds and other financial players to insure against loans gone bad." - Time, September 17, 2008
On September 1st, few knew that AIG, the largest insurance company in the world with over $1 trillion in assets, was in deep trouble. By September 12th, the rumors about major trouble were everywhere. By September 15th AIG's corporate life expectancy was being measured in days, and the question was: bankruptcy, buyer or bailout? By the evening of September 16th, the federal government had massively intervened, making an $85 billion loan to AIG in exchange for a controlling 79.9% equity share of the company.
The following case explains what caused AIG to begin a downward spiral and how and why the federal government pulled it back from the brink of bankruptcy. High Flying The epicenter of the near-collapse of AIG was an office in London. A division of the company, entitled AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of American capitalism. For years, the AIGFP division sold insurance against investments gone awry, such as protection against interest rate changes or other unforeseen economic problems. But in the late 1990s, the AIGFP discovered a new way to make money. A new financial tool known as a collateralized debt obligation (CDO) became prevalent among large investment banks and other large institutions. CDOs lump various types of debt - from the very safe to the very risky - into one bundle. The various types of debt are known as tranches. Many large investors holding mortgage-backed securities created CDOs, which included tranches filled with subprime loans. SAKEC DoMS HARDIK SAVLA: 43 Page 45

The AIGFP was presented with an option. Why not insure CDOs against default through a financial product known as a credit default swap? The chances of having to pay out on this insurance were highly unlikely, and for a while, the CDO insurance plan was highly successful. In about five years, the division's revenues rose from $737 million to over $3 billion, about 17.5% of the entire company's total. One large chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that what it insured would never have to be covered. Or, if it did, it would be in insignificant amounts. But when foreclosures rose to incredibly high levels, AIG had to pay out on what it promised to cover. This, naturally, caused a huge hit to AIG's revenue streams. The AIGFP division ended up incurring about $25 billion in losses, causing a drastic hit to the parent company's stock price. Accounting problems within the division also caused losses. This, in turn, lowered AIG's credit rating, which caused the firm to post collateral for its bondholders, causing even more worries about the company's financial situation. It was clear that AIG was in danger of insolvency. In order to prevent that, the federal government stepped in. But why was AIG saved by the government while other companies affected by the credit crunch weren't? Too Big To Fail Simply put, AIG was considered too big to fail. An incredible amount of institutional investors - mutual funds, pension funds and hedge funds - both invested in and also were insured by the company. In particular, many investment banks that had CDOs insured by AIG were at risk of losing billions of dollars. For example, media reports indicated that Goldman Sachs (NYSE:GS) had $20 billion tied into various aspects of AIG's business, although the firm denied that figure. Money market funds - generally seen as very conservative instruments without much risk attached were also jeopardized by AIG's struggles, since many had invested in the company, particularly via bonds. If AIG was to become insolvent, this would send shockwaves through already shaky money markets as millions of investors - both individuals and institutions - would lose cash in what were perceived to be incredibly safe holdings. (To learn more about the rough times money market funds saw, read Why Money Market Funds Break The Buck.)
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However, policyholders of AIG were not at too much risk. While the financial-products section of the company was facing extreme difficulty, the vastly smaller retail-insurance components were still very much in business. In addition, each state has a regulatory agency that oversees insurance operations, and state governments have a guarantee clause that will reimburse policyholders in case of insolvency. While policyholders were not in harm's way, others were. And those investors - from individuals looking to tuck some money away in a safe investment to hedge and pension funds with billions at stake needed someone to intervene. Stepping In While AIG hung on by a thread, negotiations were taking place among company and federal officials about what the next step was. Once it was determined that the company was too vital to the global economy to be allowed to fail, the Federal Reserve struck a deal with AIG's management in order to save the company. The Federal Reserve was the first to jump into the action, issuing a loan to AIG in exchange for 79.9% of the company's equity. The total amount was originally listed at $85 billion and was to be repaid over two years at the LIBOR rate plus 8.5 percentage points. However, since then, terms of the initial deal have been reworked. The Fed and the Treasury Department have loaned even more money to AIG, bringing the total up to an estimated $150 billion. Conclusion AIG's bailout has not come without controversy. Some have criticized whether or not it is appropriate for the government to use taxpayer money to purchase a struggling insurance company. In addition, the use of the public funds to pay out bonuses to AIG's officials has only caused its own uproar. However, others have said that, if successful, the bailout will actually benefit taxpayers due to returns on the government's shares of the company's equity. No matter the issue, one thing is clear. AIG's involvement in the financial crisis was important to the world's economy. Whether the government's actions will completely heal the wounds or will merely act as a bandage remedy remains to be seen.
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CREDIT DEFAULT SWAPS Market of 2009

The early months of 2009 saw several fundamental changes to the way CDSs operate, resulting from concerns over the instrument's safety after the events of the previous year. According to Deutsche Bank managing director Athanassos Diplas "the industry pushed through 10 years worth of changes in just a few months" By late 2008 processes had been introduced allowing CDSs which offset each other to be cancelled. Along with termination of contracts that have recently paid out such as those based on Lehmans, this had by March reduced the face value of the market down to an estimated $30 trillion.
[18]
U.S. and European regulators are developing
separate plans to stabilize the derivatives market. Additionally there are some globally agreed standards falling into place in March 2009, admistrated by International Swaps and Derivatives Association (ISDA). Two of the key changes are: 1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face. 2. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where its not clear what the payout should be. Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York, stated
A clearinghouse, and changes to the contracts to standardize them, will probably boost activity. ... Trading will be much easier, ... We'll see new players come to the market because theyll like the idea of this being a better and more traded product. We also feel like over time we'll see the creation of different types of products.
In the US central clearing operations began in March 2009 , operated by InterContinental Exchange (ICE). A key competitor also interested in entering the CDS clearing sector is CME Group. CME spokesman Allan Schoenberg didnt immediately respond to a request for comment.

Details for a European clearing are still being hammered out. Government Approvals Relating to Intercontinental and its competitor CME The SECs approval for ICE's request to be exempted from rules that would prevent it clearing CDSs is the third government action granted to Intercontinental this week. On March 3, its proposed acquisition of Clearing Corp., a Chicago clearinghouse owned by eight of the largest dealers in the credit-default swap market, was approved by the Federal Trade Commission and the Justice Department. On March 5, the Federal Reserve Board, which oversees the clearinghouse, granted a request for ICE to begin clearing. Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS AG, received $39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.s cash on hand and a 50-50 profit-sharing agreement with Intercontinental on the revenue generated from processing the swaps. SEC spokesperson John Nestor stated
For several months the SEC and our fellow regulators have worked closely with all of the firms wishing to establish central counterparties. ... We believe that CME should be in a position soon to provide us with the information necessary to allow the commission to take action on its exemptive requests.
Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH.Clearnet Ltd. Only the NYSE effort is available now for clearing after starting on Dec. 22. As of Jan. 30, no swaps had been cleared by the NYSEs London- based derivatives exchange, according to NYSE Chief Executive Officer Duncan Niederauer. Clearing House Member Requirements Members of the Intercontinental clearinghouse will have to have a net worth of at least $5 billion and a credit rating of A or better to clear their credit-default swap trades. Intercontinental said in
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the statement today that all market participants such as hedge funds, banks or other institutions are open to become members of the clearinghouse as long as they meet these requirements. A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded, participants are exposed to each other in case of a default. A clearinghouse also provides one location for regulators to view traders positions and prices. Other changes and debate on CDS in 2009 There is ongoing debate concerning the possibility of limiting so-called "naked" CDSs. A naked CDS is one where the buyer has no risk exposure to the underlying entity; hence naked CDSs do not hedge risk per se, but are mere speculative bets that actually create risk. Some suggest that buyers be required to have a "stake," or element of risk exposure, in the underlying entity that the CDS pays out on. Others suggest that a mere partial stake in the underlying risk is insufficient, and would insist that buyer protection be limited to insurable risk; that is, the actual value of the capital-at-risk in the underlying entity. This means the CDS buyer would have to own the bond or loan that triggers a pay out on default. Still others, also calling for the outright ban of naked CDSs, cite logic similar to that which prevailed in the call to ban markets for "terroristic events;" - namely, that it is poor public policy to provide financial incentive to one party which pay offs only when some other party suffers a loss - the argument being that it is foolish to incentivize the first party to nefariously intervene in the affairs of the second party so as to cause, or to contribute to cause, the second party loss event which has been speculated upon by the first party; such action, should it occur, is called "fomenting the loss". Regardless of the intention of the buyers and sellers of "naked" contracts, it is the absence of ownership risk that is determinate.
As part of the gradual process of financial sector liberalization in India, it is considered appropriate to introduce credit derivatives in a calibrated manner at this juncture. The risk management architecture of banks has strengthened and banks are on the way to becoming Basel II compliant, providing adequate comfort level for the introduction of such products. Furthermore, the recent amendment to the Reserve Bank of India Act, 1934 has provided legality of OTC derivative instruments, including credit derivatives. However, in view of the complexities involved in the valuation, accounting, and risk management SAKEC DoMS HARDIK SAVLA: 43 Page 50

aspects of credit derivatives and in view of the evolutionary stage of these skills among the eligible participants, the Reserve Bank has decided to initially allow only plain vanilla credit default swaps which will be a bold step into Structured Finance.
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Credit Default Swap Final

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CREDIT DEFAULT SWAPS EXECUTIVE SUMMARY

CREDIT DEFAULT SWAPS Credit Derivatives: A Brief Introduction

CREDIT DEFAULT SWAPS

CREDIT DEFAULT SWAPS

CREDIT DEFAULT SWAPS Assumptions and Extraordinary Personal Profits

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CREDIT DEFAULT SWAPS The Vital Role of Competition

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CREDIT DEFAULT SWAPS Credit Default Swap: A Credit Derivative Instrument

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Regulatory concerns over CDS

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CREDIT DEFAULT SWAPS Valuation of credit default swap (CDS)

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CREDIT DEFAULT SWAPS IS INDIA READY FOR CREDIT DEFAULT SWAPS ?

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45 n/a n/a n/a n/a 36

32.9 0.8 3.7 12.6 7.6 5.7

CREDIT DEFAULT SWAPS Positive Implications of the Introduction of CDS

billion. And the

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CREDIT DEFAULT SWAPS Negative Implications of the Introduction of CDS

CREDIT DEFAULT SWAPS

CREDIT DEFAULT SWAPS Issues Demanding Urgent Attention

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CREDIT DEFAULT SWAPS Guidelines Issued By RBI on CDS

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Amount of protection under CDS

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CREDIT DEFAULT SWAPS Provisioning Requirements

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months, protection ceases to be recognized.

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Positive Implications of the Introduction of CDS

CREDIT DEFAULT SWAPS

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CREDIT DEFAULT SWAPS Market of 2009

U.S. and European regulators are developing

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