Electronic copy available at: http://ssrn.com/abstract=1656792

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Innovative Credit Default Management in the Banks through Credit Default

Swaps- An Analysis of Credit Derivatives

________________________________________________________________________________

Name of Author: Dr. Deepak Tandon Mr. Saurabh Agarwal

Highest Degree: M.Sc., LLB, Ph.D. B.Sc. (H) Electronics,

MBA (Finance) University of Delhi, Delhi

Currently Pursuing: Professor, LBSIM*, PGDM (Fin) Final Year

Sector-11, Dwarka, Student, LBSIM,

Delhi Sector-11, Dwarka, Delhi

Mobile Number: +91- 9811688833 +91- 9953030718

Email Id: deepaktandon0@gmail .com saurabh.rdps@gmail.com

*LBSIM: Lal Bahadur Shastri Institute of Management

______________________________________________________________________________

Electronic copy available at: http://ssrn.com/abstract=1656792

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BIOGRAPHY OF AUTHORS

Dr. Deepak Tandon

With specialization in Finance, Dr. Deepak Tandon has a Work Experience of 30 years. He has been a

faculty member at eight reputed Indian Business School and has also been a trainer at Training Colleges

of various Indian Banks.

He has penned several books on banking and Forex Management, names of which are as follows:

Retail Banking; Skylark Publications; Jan 2009;ISBN -81-86141-35-9

Forex Management & Business Strategy; Skylark Publication; 2006; ISBN: 81-86141-24-3

Forex Rate Arithmetic; Skylark Publications; To be released shortly

Also, he has written and presented as many as 30 Research Papers on topics like Risk and NPA (Non

Performing Assets) Management, Hedging, Implications of Basel II norms on Indian Banks and so on.

Moreover, he has presented many papers in International Conferences conducted by leading Business

Schools like IMT, Ghaziabad, Delhi, IBS Hyderabad, IP University and the like.

Recipient of accolades in the form of Jewel of India Award and Vidya Gaurav Gold Medal Award in

2009, Dr. Tandon is also a member of Indian Institute of Banking & Finance (Mumbai), Foreign

Exchange Dealers Association of India (FEDAI), The Professional Risk Managers' International

Association (PRMIA), Wilmington, DE ,USA (Kolkata Chapter Registered member).

Mr. Saurabh Agarwal

Securing First Position in graduation at the Hans Raj College, University of Delhi, Delhi, Mr. Saurabh

Agarwal is presently pursuing Post Graduate Diploma in Management (PGDM) in Finance. Moreover, he

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has received Sh. Vijay Malhotra Prize from the University of Delhi for Academic Excellence in the year

2009.

He has a diversified background and has accomplished many live projects, mainly in the field of finance,

namely:

Analysis of Tata Steel‟s acquisition of Corus

A study of Five Year Plans in India

A detailed Financial Analysis of Infosys Technologies

Development of a Business Plan for a Mass Media School

He had also successfully completed a two month Summer Internship in the Small and Medium

Enterprises (SME) Credit Appraisal Department of Bank of India, one of India‟s leading Public

Sector Banks.

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ACKNOWLEDGEMENT

We wish to express our heartiest gratitude to all the academicians, bankers and peer group who have

contributed and inspired the authors to give such a shape. We owe sincere support and guidance to the

Director, LBSIM (Dr. K.C. Mishra), Advisor Corporate Interface, LBSIM (Dr. G.L. Sharma) for their

pervading continuous support and giving approval and trust at every moment.

Nevertheless, we thank the students of various Business Schools for their efforts and understanding the

subject knowledge. We also thank our parents for encouraging us emotionally.

The Researchers

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ABSTRACT

Credit Risk Management has always been the key concern in financing with the commercial

banks. Asset quality has to be kept in mind while bearing the various types of risks. Management

of the assets bears a significant impact on liquidity vs. risk management. Post global financial

crisis, Indian banks being in robust health can improve their performance through Credit

Derivatives. Credit Default Swaps (CDS) can be an effective tool to reduce capital and release

credit exposures to the counterparties. The authors have, through this paper, built upon the risks

associated in the system, need for credit derivatives, prevention of naked exposures through

Credit default swaps rather than using it as a hedging tool and have suggested guidelines to

eliminate counterparty risk by bringing CDS under the ambit of exchanges. Keeping in view of

the best market practices, the Central Bank also emphasized the use of Credit Default Swaps in

the coming times enabling the banks to smoothen operational and regulatory requirements.

KEY WORDS:

1. CDS – Credit default Swaps, 2.Counterparty Risks

3. Credit Derivatives 4. ISDA – International Swaps & Derivatives Association

5. OTC – Over the Counter Trade Market

JEL CLASSIFICATION

G12, G13, C14

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INTRODUCTION

Credit and Credit Risk

Short, seemingly simple and a term used very often in the contemporary scenario, Credit represents a

powerful economic concept as businesses, owing to increased Globalization, are expanding capacity,

upgrading technology and adding products to their portfolios. The term essentially means some kind of

support provided by a lender to a borrower in the form of some resource(s), which may be money or any

other form of goods. For simplicity, we will consider the resource being lent as money. The borrower of

the resources may not reimburse the lender immediately, but may arrange for some kind of a deferred

payment of the principal borrowed plus some fees (called interest in normal parlance), which is payable to

the lender in lieu of:

The risk taken by her in lending the resource(s) and

To compensate the lender for the Time Value of Money1

The term Credit automatically gives rise to another phenomenon called Credit Risk, which is described as

the risk of loss arising from a Credit Event with the counterparty i.e. the risk of loss that a lender is

exposed to, if the borrower is not able to make the repayment of her credit obligation. The two most

important causes of a Credit Default are- delinquency and insolvency. While delinquency refers to failure

to meet a loan payment by a due date, insolvency is defined as a situation where the liabilities of the

borrower exceed her assets.

_________________________________

1. Brealey, Myres , Allen , Mohanty ,Principles of Corporate Finance ( 2009) , Tata Mcgraw Hill New Delhi .If the value of

firm is less than the amount of debt , it will pay for the company to default and allow lenders to take over assets in

settlement of debt

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Few of the other important causes of Credit Risk are:

Adverse Selection, which refers to a situation wherein the borrower knows more about her

creditworthiness than the lender, giving the borrower an undue advantage, which the lender can

offset by limiting her exposure to the borrower

Moral Hazard that refers to a situation when the borrower takes undue risk against the money

borrowed, thereby putting the lender‟s money at risk

The general measure of Credit Risk is the Credit Spread, which is the difference between the interest

demanded by the lender against the lent amount and the risk free interest rate that the lender can receive

(T-Bills being the proxy). Higher the Credit Spread, higher is the Credit Risk associated with lending to

the particular borrower. Also Recovery Rate, which measures the extent to which the market value of an

obligation may be recovered if the borrower defaults, gains importance in case of a Credit Default.. A

lender can often judge the Potential Credit Loss confronted by him using few other aspects called-

Exposure at Default (EAD), Probability of Default (PD) and Loss Given Default (LGD).

Exposure at Default (EAD) refers to the amount that the lender is exposed to at the time of

default by the counterparty

Probability of Default (PD) indicates the degree of likelihood that the borrower will not be able

to make the necessary repayments on the due time

Loss Given Default (LGD) measures the amount that the lender will lose in case of a default by

the borrower.

Hence, to apparently eliminate the Credit Risk out of such transactions, a process called Credit Risk

Management (CRM) is becoming popular with the lenders, specially the banks.

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One of the most important steps in CRM is Credit Rating, carried out by Credit Rating Agencies (CRAs),

to identify the creditworthiness of a borrower such that a borrower rated higher in the Credit Rating is less

prone to default on the repayments of her liabilities, while a borrower rated low in Credit Rating is more

prone to default on the repayments2.

Therefore, Credit Rating helps quantify the Credit Risk associated with lending to a particular borrower.

But given the financial crises that we have faced over the years, the credibility of the Credit Rating

Agencies itself has come under scrutiny as they could not effectively rate several sovereign borrowers,

causing defaults, which resulted in lots of taxpayers‟ money getting lost in providing stimulus to the

ailing economy.

The other essential part of CRM is Credit Risk Mitigation, which is carried out, primarily with the help of

Asset Securitization and Credit Derivatives3. Asset Securitization refers to a transaction where financial

securities are issued against the cash flows generated from a pool of assets. During the process, the

Originating Bank, the bank which has originated the assets, transfers the ownership of such assets to the

Special Purpose Vehicle (SPV), created specifically for this purpose. The SPV issues the financial

securities to the investors and has the responsibility to service interest and repayments on such financial

instruments.

On the other hand, Credit Derivatives (CDs), which were launched as risk mitigating instruments in 1991

by Merrill Lynch, are Over the Counter (OTC) financial contracts, which transfer risks associated with

credit assets without transferring the underlying assets from the books of the originator. Hence, they are

regarded as off balance sheet financial instruments. Credit Derivatives allow the lending bank to:

Transfer Credit Risk and free up the capital to be used in other opportunities

Diversify Credit Risk

Maintain Client Relationships

Construct and manage a credit risk portfolio as per its risk preference

______________________________ 2. Stulz Rene M. Risk Management & Derivatives (2003), Cengage Learning

3. Credit Risk: A credit risk management framework, London: Credit Suisse Financial Products, 1997

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Credit Risk in Banks

Earlier established just as deposit takers, Credit, now, has become the business of banking and the

primary basis on which the performance and quality of a bank is judged. While asset quality i.e. quality of

loans, directly reflects the quality of management of the bank, it is also, sometimes, dependent on

government regulations, macroeconomic scenario and nature of bank ownership. But despite external

influences, a bank‟s Credit Risk Management is an essential component while analyzing the bank‟s loan

portfolio and financial performance.

Risk taking is central to banking but it is adequate only when these risks are reasonable, controlled and

within the financial resources and credit competence of the bank. Assets, primarily the loans, must be

liquid enough so that they can cover all withdrawals, expenses and losses and still earn the bank a

handsome profit, which can compensate the bank‟s shareholders. Hence, management of assets becomes

quintessential for a bank, not just to make profits but also in order to survive.

Credit risk is one of the risks to which banks are continuously and largely exposed. Therefore, effective

management of credit risk becomes extremely important for a bank to ensure its strong financial health.

While, banks in India have developed reasonably fair skills and systems to mitigate credit risks, the

options available to them to control credit risk have been confined to the orthodox methods of

Securitization of assets, obtaining credit guarantee protection and obtaining credit insurance. But, while

banks have been provided with options to tackle interest rate risk and foreign risk using derivatives,

Credit Derivatives are still to find their way into India, though RBI is doing the groundwork to make the

banking industry robust and sound by allowing these instruments in India.

Credit Derivatives

As mentioned earlier, Credit Derivatives are used to mitigate and manage credit risk faced by a lender.

Under a Credit Derivative transaction, a Protection Buyer (PB), enters into an agreement with the

Protection Seller (PS) to transfer the Credit Risk with reference to a Notional Value of the Reference

Asset, by agreeing to pay regular Premium to the Protection Seller. In the instance of a Credit Event

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(delinquencies, default, foreclosure, prepayment, etc.) taking place with reference to the Reference

Obligation, under a Settlement, the Protection Seller compensates the Protection Buyer for the losses

incurred as a result of the Credit Event. The Settlement can be a Physical Settlement, a Cash Settlement or

a Fixed Amount Settlement.

Under a Physical Settlement, the Protection Buyer delivers the Reference Asset to the Protection

Seller and in return the Protection Seller pays out the par value plus the accrued interest of the

Reference Asset

In a Cash Settlement, the Protection Seller pays the Protection Buyer the loss suffered i.e.

difference between the par value plus accrued interest and the market value of the defaulted

reference obligation or estimated recoveries

Under a Fixed Amount Settlement, the Protection Buyer is paid a fixed amount by the Protection

Seller

Credit Derivatives can be divided into 2 broad categories, namely:

Transactions where credit protection is bought and sold

Total return swaps

A detailed description of both these types is as follows:

Transactions Where Credit Protection Is Bought and Sold

(i) Credit Default Swap (CDS)

It is a bilateral derivative contract on one or more Reference Assets in which the Protection Buyer pays a

fee, called premium, through the life of the contract in return for a Credit Event payoff by the Protection

Seller following a Credit Event of the reference entities. In most instances, the Protection Buyer makes

periodic payments to the Protection Seller. The periodic payment is typically expressed in terms of the

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CDS Spread, the annualized percentage of a transaction‟s notional amount. In the instance that no pre-

specified credit event occurs during the life of the transaction, the Protection Seller receives the periodic

payments in compensation for assuming the credit risk on the Reference Entity/Obligation.

Conversely, in the instance that any one of the Credit Events occurs during the life of the transaction, the

Protection Buyer will receive a credit event payment, which will depend upon whether the terms of a

particular CDS call for a physical settlement, cash settlement or fixed amount settlement. With few

exceptions, the legal framework of a CDS – that is, the documentation evidencing the transaction – is

based on a confirmation document and legal definitions set forth by the International Swaps and

Derivatives Association, Inc. (ISDA)4.

If a Credit Event occurs and physical settlement applies, the transaction shall accelerate and Protection

Buyer shall deliver the Deliverable Obligations (for instance, a bond) to Protection Seller against payment

of a pre-agreed amount.

If a Credit Event occurs and cash settlement applies, the transaction shall accelerate and Protection Seller

shall pay to Protection Buyer the excess of the par value of the Deliverable Obligations on start date over

the prevailing market value of the Deliverable Obligations upon occurrence of the Credit Event. The

procedure for determining market value of Deliverable Obligations is based on ISDA definitions or may

be defined in the related confirmation and some cases a pre-determined amount agreed by both parties on

inception of the transaction is paid. The structures of physically settled CDS and cash settled CDS are

shown in Figure 1 and Figure 2 respectively.

______________________________ 4. Hull John C, Options, Futures and Other Derivatives, Pearson & Co.The regular payments from the buyer of protection

to the seller of protection cease when there is a credit event.

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Figure 1

Physically Settled Credit Default Swap

Figure 2

Cash Settled Credit Default Swaps

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The following graph indicates the rapidly growing market size of CDS:

Here we can notice that the CDS market size (expressed in terms of the Notional Value) had been

growing at a very rapid rate reaching its peak in 2007, when the risks associated with the instrument

yielded haunting results by bringing the global economy to a standstill. Since then, the players in the

market have become cautious, thereby reducing the Notional Amounts for which CDS are traded.

(ii) Credit Default Option

It is a kind of CDS where the fee is paid fully in advance.

(iii) Credit Linked Note (CLN)

It is a combination of a regular note and a credit-option. Since it is a regular note with coupon, maturity

and redemption, it is an on-balance sheet equivalent of a credit default swap. Under this structure, the

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coupon or price of the note is linked to the performance of a reference asset. It offers lenders a hedge

against credit risk and investors a higher yield for buying a credit exposure synthetically rather than

buying it in the publicly traded debt. CLNs are generally created through a Special Purpose Vehicle

(SPV), or trust, which is collateralized with highly rated securities. CLNs can also be issued directly by a

bank or financial institution. Investors buy the securities from the trust (or issuing bank) that pays a fixed

or floating coupon during the life of the note. At maturity, the investors receive par unless the referenced

credit defaults or declares bankruptcy, in which case they receive an amount equal to the recovery rate.

Here the investor is, in fact, selling credit protection in exchange for higher yield on the note. The Credit-

Linked Note allows a bank to lay off its credit exposure to a range of credits to other parties.

(iv) Credit Linked Deposits/ Credit Linked Certificates of Deposit

Credit Linked Deposits (CLDs) are structured deposits with embedded default swaps. Conceptually they

can be thought of as deposits along with a default swap that the investor sells to the deposit taker. The

default contingency can be based on a variety of underlying assets, including a specific corporate loan or

security, a portfolio of loans or securities or sovereign debt instruments, or even a portfolio of contracts

which give rise to credit exposure. If necessary, the structure can include an interest rate or foreign

exchange swap to create cash flows required by investor. In effect, the depositor is selling protection on

the reference obligation and earning a premium in the form of a yield spread over plain deposits. If a

credit event occurs during the tenure of the CLD, the deposit is paid and the investor would get the

Deliverable Obligation instead of the Deposit Amount.

(v) Repackaged Notes

Repackaging involves placing securities and derivatives in a Special Purpose Vehicle (SPV) which then

issues customized notes that are backed by the instruments placed. The difference between repackaged

notes and CLDs (Credit Linked Deposits) is that while CLDs are default swaps embedded in

deposits/notes, repackaged notes are issued against collateral - which typically would include cash

collateral (bonds / loans / cash) and derivative contracts. Another feature of Repackaged Notes is that any

issue by the SPV has recourse only to the collateral of that issue.

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(vi) Collateralized Debt Obligations (CDOs)

CDOs are specialized repackaged offerings that typically involve a large portfolio of credits. Both involve

issuance of debt by a SPV based on collateral of underlying credit(s). The essential difference between a

repackaging programme and a CDO is that while a simple repackaging usually delivers the entire risk

inherent in the underlying collateral (securities and derivatives) to the investor, a CDO involves a

horizontal splitting of that risk and categorizing investors into senior class debt, mezzanine class and a

junior debt. CDOs may be further categorized, based on the structure with which funding is raised. The

funding could be raised by issuing bonds, which are called Collateralized Bond Obligations (CBOs) or by

raising loans, which are called Collateralised Loan Obligations (CLOs).

Total Return Swaps

Total Return Swaps (TRS), also called Total Rate of Return Swaps (TROR) are bilateral financial

contracts designed to synthetically replicate the economic returns of an underlying asset or a portfolio of

assets for a pre-specified time. One counterparty (the TR payer) pays the other counterparty (the TR

receiver) the total return of a specified asset, the reference obligation. In return, the TR receiver typically

makes regular floating payments. These floating payments represent a funding cost. In effect, a TRS

contract allows the TR receiver to obtain the economic returns of an asset without having to fund the

assets on its balance sheet. Should the underlying asset decline in value by more than the coupon

payment, the TR receiver must pay the negative total return, in addition to the funding cost, to the TR

payer. At the extreme, a TR receiver can be liable for the extreme loss that a reference asset may suffer

following, for instance, the issuing company‟s default.

As such, a TRS is a primarily off-balance sheet financing vehicle. In contrast to credit default swaps,

which only transfer credit risk, a TRS transfers not only to credit risk (i.e. the improvement or

deterioration in credit profile of an issuer), but also market risk (i.e. any increase or decrease in general

market prices). In TRS, payments are exchanged among counterparties upon changes in market valuation

of the underlying, in addition to the occurrence of a credit event as is the case with CDS contracts.

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Risks Associated With Credit Default Swaps

A CDS may be used by:

A Protection Buyer to buy protection on specified loans or advances or investments where the PB

has a credit risk exposure

A Protection Seller to sell protection on specified loans or advances or investments where the PB

has a credit risk exposure

Speculators to make profits in the traded instrument by betting on the probability of default by the

Reference Entity

Also a CDS induces payment to the PB in case of a Credit Event, which may arise because of:

Bankruptcy of the Reference Entity

Obligation Acceleration

Obligation Default

Failure to Pay

Moratorium/ Repudiation

Restructuring faced by the Reference Entity

Through CDS, the Protection Buyer, who is also the lender to the Reference Entity, can transfer her credit

exposure to the Protection Seller. Also, there are a number of variations in CDS. In a binary CDS, the

payoff in the Credit Event is a fixed amount. In a basket CDS, there are a number of Reference Entities,

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against which the CDS is entered into. In a contingent CDS, the payoff requires both a Credit Event and

an Additional Trigger. The Additional Trigger might be a Credit Event with respect to another Reference

Entity or a specified movement in some market variable. On the other hand, in a dynamic CDS, there is a

notional amount determining mark to market value of a portfolio of swaps.

The various risks associated with a CDS transaction are as follows:

1. Credit Risk from two sources

The buyer of CDS protection bears most of the risk of the swap, because the main risk of credit default

swaps is that the seller of protection is unable to pay in the case of a Credit Event that is covered by the

CDS contract. In other words, while a credit default swap is supposed to protect the Protection Buyer

from credit risk of the Reference Entity, it does not protect her against the credit risk associated with the

Protection Seller. Furthermore, if the Protection Seller defaults, then the Protection Buyer suffers losses

from both the Referenced Credit Event of the Reference Entity and from the loss of premium paid to the

CDS seller.

Hence, a Protection Seller must have a good credit rating, and if its credit rating declines, most CDS

contracts require that the Protection Seller post more collateral to protect the Protection Buyer. This is

what precipitated the American International Group‟s (AIG) freefall to inevitable bankruptcy before the

United States government bailed it out with an $85 billion loan. Evidently, the traders in the CDS

department of AIG considered the premium to be virtually free money, since they did not hedge their own

risk, and they sold a lot more protection than what they could actually cover. Worse still, most of the

protection was for the mortgage-backed securities based on subprime mortgages that started defaulting in

significant numbers in 2008, due to falling realty prices, causing the Credit Rating Agencies to

downgrade the credit rating of AIG, which, by force of contract, required AIG to post more collateral for

the Credit Default Swaps, which it had sold. It became acutely obvious that AIG didn‟t really have the

capital to cover all of its CDS buyers. Therefore, because of the danger of credit contagion, which is when

the default of one company causes a cascade of defaults to other companies, the United States

government bailed out AIG to prevent more defaults, and more credit contagion from undermining the

financial institutions of the United States.

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2. Regulation of CDS

Since, the payoff on a CDS depends on the default of a specific borrower, such as a corporation, or of a

specific security, such as a bond, its value is, especially, sensitive to the state of the overall economy. If

the economy moves toward a recession, for example, the likelihood of defaults increases and the expected

payoff on credit default swaps can rise quickly.

The CDS market is entirely unregulated and there are no public records showing whether sellers have the

assets to pay out if a bond defaults, primarily, because they are considered bilateral contracts. These

counterparties include JPMorgan Chase, the largest seller and buyer of CDSs. Sellers of protection aren't

required by law to set aside reserves in the CDS market. While banks ask Protection Sellers to put up

some money when making the trade, there are no industry standards.

The unregulated nature of credit default swaps has been blamed for playing a major role in the recent

abrupt demise of Bear Stearns, the dramatic bankruptcy filing of Lehman Brothers, the federal rescue of

American International Group and Bank of America‟s acquisition of Merrill Lynch. Also, the CDS is not

traded on an exchange and is a non standardized, tailor made financial instrument to suit the investor‟s

needs. Though International Swaps and Derivatives Association was chartered in 1985 to identify and

reduce the risks associated with OTC derivatives, its success can be gauged from the recent Financial

Crisis, which was a result of lax policies in the derivatives segment5.

3. From Hedging to Speculation

Although CDSs were designed to offer legitimate protection to those seeking to hedge or transfer credit

risk, some argue that manipulative practices in the CDS market have contributed to the demise of entities

like Lehman Brothers, the AIG and the like, as well as to the general market turmoil.

____________________________ 5. Green, R., B. Hollifield, and N. Schurhoff, “Financial Intermediation and the Costs of Trading in an Opaque Market,”

Review of Financial Studies 20, 2007, pp. 275314.

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Speculation entered the CDS market in three forms:

Using structured investment vehicles such as MBS, ABS, CDO and Structured Investment

Vehicle (SIV) securities as the underlying asset

Creating CDS between parties without any connection to the underlying asset

Development of a secondary market for CDS

Much has been written about the SIV market and the lack of understanding of what was included in the

various products. Sellers of protection in the CDS market did not have sufficient understating of the

underlying asset to determine an appropriate risk profile (plus there was no history of these products to

assist in determining a risk profile). As it has become clear, the SIV market was a speculative market

which was not really understood thereby leading to speculative CDS related to these products.

A larger problem is the pure speculation in the CDS market. Many hedge funds and investment

companies started to write CDS contracts without owning the underlying security, giving them a shape of

a bet on whether a credit event would occur or not. These CDS contracts created a way to short sell the

bond, or to make money on the decline in the value of bonds. Many hedge funds and other investment

companies often place bets on the price movement of commodities, interest rates, and many other items,

and now had a vehicle to short the credit markets.

A still larger problem was the development of a secondary market for both legs of the CDS product,

particularly the Protection Sellers. The problem may be that a weak link would occur in the chain of sales

even if the CDS terms are the same. The weak link is often a speculative buyer that offers to sell

protection, but, in fact, is just looking to quickly turn the product to another investor. This problem

becomes particularly acute when the CDS is based on SIV and firms looking for quick and easy profits.

An insurance company may unknowingly be pulled into one of these speculative aspects of the CDS

market. The insurance company would be viewed as the deep pocket and may be asked to recover losses

by the Protection Buyer.

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High speculation in the CDS market, in case of the European Sovereign Crisis, caused the Spreads to

shoot up giving the investors an impression that the sovereign bond issuers are more likely to default on

the repayments. This, in turn, created chaos in the market with all hedgers striving for protection to

immune themselves from the Credit Event, which again lead to sharp increase in the Spreads, thereby

forming a vicious circle.

As a result, in 2010, Germany, in order to prevent speculation in the CDS market, on bonds issued by the

16 Euro using countries, banned all naked short trades until March 31, 2011. The move made sense as

there is no reason why someone who did not possess the underlying security, gets insured against any

credit default on that security. The ban was cheered by some European nations as they had seen tough

times owing to reckless use of CDSs by various hedge funds and other financial institutions. Speculation

on CDS can easily be regarded as legalized betting, wherein the speculator, the Protection Buyer, bets for

a credit default on the repayment of the Reference Entity i.e. the borrower without having any exposure to

credit risk associated with the Reference Entity.

CDS and the Financial Crisis of 2007-09

Credit default swaps were seen as easy money for banks when they were first launched as the economy

was booming and corporate defaults were few back then, making the swaps a less risky way to collect

premium and earn extra cash. This resulted in the market size of CDS increasing to a whopping $50 tn in

2009, beating the US stock market sized around $22 tn. Also, as per ISDA Derivatives Usage Survey

2009, over 90% of the Fortune 500 companies use CDSs to manage their risks.

The swaps focused primarily on municipal bonds and corporate debt in the 1990s, not on structured

finance securities. Investors flocked to the swaps in the belief that big corporations would seldom go bust

in such flourishing economic times. The CDS market then expanded into structured finance, such as

CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative

investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having

any direct relationship with the underlying investment referred to as „naked trading‟.

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Prior to the financial crisis of 2007-09, as the Federal Reserve cut interest rates and Americans

started buying homes in record numbers, mortgage-backed securities became the hot new

investment. Mortgages were pooled together, and sliced and diced into bonds that were bought

by just about every financial institution imaginable: investment banks, commercial banks, hedge

funds, pension funds. For many of those Mortgage-Backed Securities (MBSs), Credit Default

Swaps were taken out to protect against the default. But soon, as Realty prices, in the US,

plunged causing these MBSs to go bad and not just the lenders but the CDS writers faced

bankruptcy, as they did not have much capital to service these CDSs in case of the Credit Events,

which had occurred in large numbers. Hence, governments all over the world had to bail them out with

the taxpayer‟s money. This resulted in CDS spreads rising, indicating that investors had to pay more for

getting protection from the borrowers.

Also, during the Sovereign Debt Crisis in Europe, faced, primarily, by the PIGS (Portugal, Italy, Greece

and Spain), the spread on 5 year Greek and Portugal sovereign bonds breached all marks, indicating that

the probability of a Credit Event was very high on the sovereign bonds issued by these countries.

The following graph indicates the CDS Spreads of various countries that were facing fears of rising Credit

Defaults both by the governments and other financial institutions. As indicated in the g graph, the CDS

Spread was the highest for investors seeking protection against the Dubai sovereign bonds. Dubai, which

saw a continuous decline in property prices, had a huge debt pile of over $80 bn, with the country‟s

flagship conglomerate, Dubai World, undergoing restructuring of a debt pile of around $26 bn. The

Spread eased a little after Abu Dhabi offered a relief of $10 bn to Dubai as assistance to pay off latter‟s

debts.

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But by the end of 2009, outstanding Notional amounts on CDS contracts continued to decline (-9%),

albeit at a slower pace than in the first half of 2009 (-14%). CDS gross market values shrank by 40%, a

similar rate of decline to that seen in the first half of the year (-42%). This brought the market value of the

CDS contracts down to 35% of its end-2008 peak.

Credit Derivatives in India

Keeping in mind, the growing need and importance of Credit Risk Mitigation and with a view to develop

the bond market, the Reserve Bank of India (RBI), as a step towards enhancing the risk management

system in Indian banks, drafted its first guidelines pertaining to Credit Risk Management in 2001. Later,

in 2003 a draft paper was put forward for discussion by banks, financial institutions and other market

participants. This was followed by another circular in 2008 whereby the RBI announced that the

introduction of Credit Derivatives in India would be suspended temporarily given the huge risks involved

in them, which brought down the entire global economy down in 2007.

23

But to ensure that the lenders are protected, the RBI is again focusing on launching CDs but with caution

as they are not regulated by any exchange, as they are OTC products, and are not standardized. Also,

given the huge risks associated with the instrument, particularly the CDS, there are other concerns

pertaining to the capital required by the CDS writers and their Credit Rating. This is because, it needs to

be ensured that the CDS writers have enough capital to service the CDS in case of the Credit Event,

which also decides there Credit Rating. A better rated CDS writer, obviously, is less prone to make

defaults in servicing the CDS it writes.

The recent guidelines of RBI pertaining to CDS mandate that CDS should only be allowed with corporate

bonds as Reference Obligation. Also, the RBI categorized the players involved as Market Makers, who

can buy and sell the CDSs and Users, who can only buy CDS contracts. The RBI allowed commercial

banks, primary dealers and NBFCs (that offer credit facilities to borrowers) to act as market-makers,

subject to the laid eligibility criteria. Also, Insurance companies and mutual funds may also be permitted

to sell CDS on single name corporate bonds, subject to their having strong financials and risk

management capabilities as prescribed by their regulators IRDA and SEBI. The users category would

comprise commercial banks, primary dealers, NBFCs, mutual funds, insurance companies, housing

finance companies, provident funds and listed corporates. Further norms are as follows:

Banks who intend to sell CDS protection should have a minimum Net Worth of Rs 500 cr and a

CRAR of atleast 12% with core CRAR (Tier I) of at least 8% and net NPAs of less than or equal

to 3%

All other Protection Sellers should have minimum net owned funds of Rs. 500 crore, minimum

CRAR of 15% and net NPAs of less than or equal to 3%

The Protection can be sold against risks of a single issue, unlike AIG, which provided protection

for Mortgage Backed Security representing thousands of unknown home loans

The protection can be sold only to people who actually are exposed to the credit risk, thereby

eliminating speculation by way of naked short selling, which provides a legal platform to

investors to bet against the Reference Entity

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Protection can be bought to the extent of the reference obligation both in terms of the amount and

tenor

A limited number of parties can issue protection, unlike in the US, where there were too many

CDS writers, thereby creating a widespread crisis, when the Reference Entities started defaulting

Also, the Fixed Income Money Markets and Derivatives Association of India (FIMMDA) in

consultation with market participants and market bodies should coordinate in the matters relating

to documentation, disclosure of daily CDS curve for valuation and setting up of determination

committees

The Protection Buyer has her credit exposure towards the Protection Seller

Also, while introducing CDSs, consideration should be paid to what happened to the US and the

European countries, which had used this instrument carelessly. Therefore, there should be an upper limit

set on the Notional Value on which a CDS is bought, especially for the speculators.

If at all there is to be a secondary market for CDSs, enabling exchanges to trade CDS can serve as a very

safe move as the exchange, then, acts as the counterparty for both the buyer and writer, thereby ensuring

there is minimum or no Counterparty Risk associated with the transaction6. But experts say that such a

move can act as a deterrent to the volumes traded as exchange traded contracts, unlike OTC contracts, are

standardized and may or may not meet every Protection Buyer‟s needs. But such an argument cannot be

considered valid given the huge risk involved in the transaction, which led the entire economy into

recession in 2007.

But, if CDS are allowed to be traded on exchanges, its regulation might become a concern just as it

happened with Ulips, where there was a fight between SEBI and IRDA over regulation of the instrument.

It will have to be pre-decided as to under whose ambit will the regulation of CDS come, so that there is no

further confusion later on, once the instrument is introduced.

_____________________________ 6. D. Duffie and H. Zhou, “When Does a Central Clearing Counterparty Reduce Counterparty Risk?” Working Paper,

Graduate School of Business, Stanford University, July 1, 2009.

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Also, focusing on driving greater usage of Central Counterparty Clearing facilities (CCPs) can be a good

method to eliminate or reduce the counterparty risks. Presently, world over, derivatives representing just a

third of the total outstanding notional principal have been cleared by the CCPs, so there lies a huge scope

of development in this regard to strengthen the Counterparty Risk Management.

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OBJECTIVES OF THE STUDY

The Research, essentially, aims to study the importance of Credit Derivatives, especially, the CDS while

focusing equally on the risks associated with it.

The Primary Objective of the research is:

(i) To study Credit Default Swaps and their role in the financial meltdown of 2007-09 so that a proper

path for their introduction in India can be laid down

(ii) To study the par spread and pricing of CDS

The Secondary Objectives of the research are:

To study Credit Derivatives (CDs) and their importance in mitigating credit risk; and identify the

risks associated with usage of CDs

To study Credit Default Swaps (CDSs) and the risks associated with them

To recommend, broadly, certain aspects that need to be taken care of while introducing the very

risky CDSs in India

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METHODOLOGY

CDS transfer the risk that a certain individual entity defaults from the “protection buyer” to the

“protection seller” in exchange for the payment of a premium. They are the most frequently traded credit

derivative. 6 Commonly, CDS have a maturity of one to ten years with most of the liquidity concentrated

on the five year horizon. The details of a CDS transaction are recorded in the CDS contract, which is

usually based on a standardised agreement prepared by the International Swaps and Derivatives

Association (ISDA), an association of major market participants7. The contract defines all “credit events”

where the protection seller needs to compensate the protection buyer. Typically five events are included:

The reference entity fails to meet payment obligations when they are due

Bankruptcy

Repudiation

Material adverse restructuring of debt

Acceleration or Default of Obligation

In a CDS transaction, the premium, which the buyer of credit risk (i.e. the protection seller) receives is

expressed as an annualised percentage of the notional value of the transaction and this value is recorded

as the “market price” of the CDS in data bases such as Bloomberg.

For designing Credit Default Swaps a robust market infrastructure and systemic monitoring

system is required and if the banks in India are allowed CDS, corporates have to capture hedging

for purpose of market based risk intermediation.

__________________________ 7. Goldstein, M., E. Hotchkiss, and E. Sirri, “Transparency and Liquidity: A Controlled Experiment on Corporate Bonds,”

Review of Financial Studies 20, 2007, pp. 235- 273.

28

29

30

Thus, despite these risks to the CDX options, under normal market conditions pricing and

hedging the options for market makers and users is not difficult. There are several academic

models to price options on individual CDS options including a SSRD model and a Black‟s-like

model. These models require the user to estimate two unobservable variables: credit spread

volatility and the recovery rate on the reference asset. Options on CDS indexes would also

require the user to estimate the correlation between the CDS in the index using historical data or

current CDX tranche prices. While there is no single accepted model for pricing CDX options,

there are enough decent models to allow players to price and trade the CDX options. In fact there

31

are already software packages, such as FinCAD, that have functions for pricing CDS index

options.Any model on CDX options will generate an option delta that will allow a user to delta

hedge the CDX options with the frequently-traded CDX index. In general, exchanges are

agnostic to pricing models. Contracts currently trade on the VIX volatility index, options for

which there is no agreed-upon pricing model and for which traders use different models.32

Pricing and hedging the CDX options will not be a limiting factor on the exchange-traded CDX

option market.

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CONCLUSION

Though Credit Derivatives are very useful instruments for the lenders to protect them from

Credit Risk, their excessive usage during 2007-08 resulted in huge losses to the CDS writers and

hence to the CDS buyers, each of whom, earlier, had a different opinion about corporate

defaults8. Hence, as a result the governments, across many parts of the world, had to bail out the

market makers with taxpayers‟ money.

This was a result of CDS, introduced as hedging instruments, being recklessly used for

speculation, which was not completely justified. Moreover, there were loopholes in the

regulation of CDS brining in cascaded counterparty risks.

Hence, before the introduction of CDS in India, a proper regulatory environment needs to be

developed, which can help eliminate or reduce all or most of the risks associated with CDSs, so

that they end up being, actually, used as hedging instruments rather than speculating instruments,

which, somehow, defeat their entire purpose.

_____________________________ 8. Madura Jeff, International Financial Management –(2008) Cengage Learning

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RECOMMENDATIONS

Given the importance of Credit Risk Management in lending institutions, Credit Derivatives

(CDs) gain a center stage to help these institutions mitigate risks, especially the Credit Risk. But

the CDs, obviously, come with certain drawbacks, which make the instrument very risky.

Therefore, CDs, especially Credit Default Swaps (CDSs) need to be dealt with caution. Various

recommendations that have been made in here are as follows:

Checking speculation on CDSs, by checking naked trading of CDS, as they were

invented with a view to protect the lenders, who, of course had the underlying in

possession

Focusing on regulation of the instrument, which includes:

o Making sure that CDS writers have enough capital to service obligations that arise

from a the Credit Event in the CDS transaction9

o Eliminating counterparty risks by bringing CDS under the ambit of exchanges,

which can indeed simplify their regulation and make transactions more

transparent

Taking care that not many CDS writers have exposure to a particular Reference Entity,

which would increase their risk, if the Credit Event occurs against that Reference Entity

_____________________________ 9. Allen C. Shapiro, Multinational Financial Management, 8th Edition, Wiley & Co

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Also, regulation of CDS may lead to confusion, once it is allowed to be traded on the

exchange, over the body under whose ambit it comes. Hence, such a problem should be

dealt with now only, much before it takes the shape of the regulatory issues associated

with Ulips

If these measures are taken, CDS can actually become risk mitigating instruments, a role which

they were meant to play, but apparently did not play during 2007-09, thereby bringing the entire

global economy down.

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CITATION

Books:

1. Goldstein, M., E. Hotchkiss, and E. Sirri (2007), “Transparency and Liquidity: A

Controlled Experiment on Corporate Bonds,” Review of Financial Studies 20

2. Green, R., B. Hollifield, and N. Schurhoff (2007), “Financial Intermediation and the

Costs of Trading in an Opaque Market,” Review of Financial Studies 20

3. Madura Jeff (2008), International Financial Management, Cengage Learning, New Delhi

4. Brealey, Myres, Allen , Mohanty ( 2009), Principles of Corporate Finance, Tata Mcgraw

Hill, New Delhi

5. Harrington Niehaus (2008), Risk Management & Insurance (3rd

Edition) Tata Mcgraw

Hill, New Delhi

6. Stulz Rene M. (2003), Risk Management & Derivatives (2003), Cengage Learning, New

Delhi

7. Allen C. Shapiro (2007), Multinational Financial Management (8th

Edition), Wiley &

Co., New Delhi

8. Hull John C. (2009), Options, Futures and Other Derivatives (7th

Edition), Pearson & Co.

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Journals:

1. D. Duffie and H. Zhou, “When Does a Central Clearing Counterparty Reduce

Counterparty Risk?” Working Paper, Graduate School of Business, Stanford University,

July 1, 2009

2. Credit Risk: A credit risk management framework, London: Credit Suisse Financial

Products, 1997