Creadit risk management

8/7/2019 Creadit risk management

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Chapter 1: Introduction

Introduction

Credit risk arises from the possibility of default by

counterparty. Credit risk lay at the heart of the sub prime

crisis. The most important point to note about credit risk is

that it is more difficult to model and measure compared to

market risk. Unlike market risk, where a lot of data is

available in the public domain, data is scanty and sometimes

non existent in case of credit risk. Moreover, credit risk is

far more contextual, i.e., firm specific compared to market

risk. Despite these challenges, there has been significant

progress in credit risk modeling in recent years. In this

chapter, we will examine the three building blocks of credit

risk management probability of default, exposure at default

and recovery rate. We will also discuss briefly some of the

commonly used credit risk modeling techniques. These

techniques can help us to estimate the potential loss in a

portfolio of credit exposures over a given time horizon at a

specified confidence level. The aim of this chapter is to

provide a high level understanding of credit risk

management.

Credit risk is an investor's risk of loss arising from a

borrower who does not make payments as promised. Such an

event is called a default. Another term for credit risk is

default risk.

Investor losses include lost principal and interest, decreased


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cash flow, and increased collection costs, which arise in a

number of circumstances:

A consumer does not make a payment due on a mortgage

loan, credit card, line of credit, or other loan

A business does not make a payment due on a mortgage ,

credit card, line of credit, or other loan

A business or consumer does not pay a trade invoice when

due

A business does not pay an employee's earned wages when

due

A business or government bond issuer does not make a

payment on a coupon or principal payment when due

An insolvent insurance company does not pay a policy

obligation

An insolvent bank won't return funds to a depositor

A government grants bankruptcy protection to an insolvent

consumer or business

Credit risk is an investor's risk of loss arising from a

borrower who does not make payments as promised. Such an

event is called a default. Another term for credit risk is

default risk.


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Chapter 2 : Credit Risk Management in Banks

2.1 Principles for the Management of Credit Risk

1. While financial institutions have faced difficulties over

the years for a multitude of reasons, the major cause of

serious banking problems continues to be directly related to

lax credit standards for borrowers and counterparties,

poor portfolio risk management, or a lack of attention to

changes in economic or other circumstances that can lead to

a deterioration in the credit standing of a bank's

counterparties. This experience is common in both G-10 and

non-G-10 countries.

2. Credit risk is most simply defined as the potential that a

bank borrower or counterparty will fail to meet its

obligations in accordance with agreed terms. The goal of

credit risk management is to maximise a bank's risk-adjustedrate of return by maintaining credit risk exposure within

acceptable parameters. Banks need to manage the credit risk

inherent in the entire portfolio as well as the risk in

individual credits or transactions. Banks should al so consider

the relationships between credit risk and other risks. The

effective management of credit risk is a critical component

of a comprehensive approach to risk management and

essential to the long-term success of any banking

organisation.

3. For most banks, loans are the largest and most obvious

source of credit risk; however, other sources of credit risk


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exist throughout the activities of a bank, including in the

banking book and in the trading book, and both on and off

the balance sheet. Banks are increasingly facing credit risk

(or counterparty risk) in various financial instruments other

than loans, including acceptances, interbank transactions,

trade financing, foreign exchange transactions, financial

futures, swaps, bonds, equities, options, and in the extension

of commitments and guarantees, and the settlement of

transactions.

4. Since exposure to credit risk continues to be the leading

source of problems in banks world-wide, banks and their

supervisors should be able to draw useful lessons from past

experiences. Banks should now have a keen awareness of the

need to identify, measure, monitor and control credit risk as

well as to determine that they hold adequate capital against

these risks and that they are adequately compensated for

risks incurred. The Basel Committee is issuing this

document in order to encourage banking supervisors

globally to promote sound practices for managing credit risk.

Although the principles contained in this paper are most

clearly applicable to the business of lending, they should be

applied to all activities where credit risk is present.

5. The sound practices set out in this document specifically

address the following areas: (i) establishing an appropriate

credit risk environment; (ii) operating under a sound credit-

granting process; (iii) maintaining an appropriate credit


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administration, measurement and monitoring process; and

(iv) ensuring adequate controls over credit risk. Although

specific credit risk management practices may differ among

banks depending upon the nature and complexity of their

credit activities, a comprehensive credit risk management

program will address these four areas. These practices

should also be applied in conjunction with sound practices

related to the assessment of asset quality, the adequacy of

provisions and reserves, and the disclosure of credit risk, all

of which have been addressed in other recent Basel

Committee documents.

6. While the exact approach chosen by individual

supervisors will depend on a host of factors, including their

on-site and off-site supervisory techniques and the degree to

which external auditors are also used in the supervisory

function, all members of the Basel Committee agree that the

principles set out in this paper should be used in evaluating a

bank's credit risk management system. Supervisory

expectations for the credit risk management approach used

by individual banks should be commensurate with the scope

and sophistication of the bank's activities. For smaller or less

sophisticated banks, supervisors need to determine that the

credit risk management approach used is sufficient for their

activities and that they have instilled sufficient risk -return

discipline in their credit risk management processes.

7. The Committee stipulates in Sections II through VI of the


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paper, principles for banking supervisory authorities to apply

in assessing bank's credit risk management systems. In

addition, the appendix provides an overview of credit

problems commonly seen by supervisors.

8. A further particular instance of credit risk relates to the

process of settling financial transactions. If one side of a

transaction is settled but the other fails, a loss may be

incurred that is equal to the principal amount of the

transaction. Even if one party is simply late in settling, thenthe other party may incur a loss relating to missed

investment opportunities. Settlement risk (i.e. the risk that

the completion or settlement of a financial transaction will

fail to take place as expected) thus includes elements of

liquidity, market, operational and reputational risk as well as

credit risk. The level of risk is determined by the particular

arrangements for settlement. Factors in such arrangements

that have a bearing on credit risk include: the timing of the

exchange of value; payment/settlement finality; and the role

of intermediaries and clearing houses.


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Chapter 3: Settlement Risk

3.1 Presettlement vs. Settlement Risk

Counterparty credit risk consists of both presettlement and

settlement risk. Preset- tlement risk is the risk of loss due to

the counterpartys failure to perform on an obligation during

the life of the transaction. This includes default on a loan or

bond or failure to make the required payment on a

derivative transaction. Presettlement risk can exist over long

periods, often years, starting from the time it is contracted

until settlement.

In contrast, settlement risk is due to the exchange of cash

flows and is of a much shorter-term nature. This risk arises as

soon as an institution makes the required payment until the

offsetting payment is received. This risk is greatest when

payments occur in different time zones, especially forforeign exchange transactions where nationals are exchanged

in different currencies. Failure to perform on settlement can

be caused by counterparty default, liquidity constraints, or

operational problems.

Most of the time, settlement failure due to operational

problems leads to minor economic losses, such as additional

interest payments. In some cases, however, the loss can be

quite large, extending to the full amount of the transferred

payment. An example of major settlement risk is the 1974

failure of Herstatt Bank. The day it went bankrupt, it had

received payments from a number of counterparties but


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defaulted

before payments were made on the other legs of the

transactions.

3.2 Handling Settlement Risk

In March 1996, the Bank for International Settlements (BIS)

issued a report warning that the private sector should find

ways to reduce settlement risk in the $1.2 trillion-a- day global

foreign exchange market.1

The report noted that central bankshad significant concerns regarding the risk stemming from

the current arrangements for settling FX trades. It explained

that the amount at risk to even a single counterparty could

exceed a banks capital, which creates systemic risk. The

threat of regulatory The action led to reexamination of

settlement risk status of a trade can be classified into five

categories:

Revocable: when the institution can still cancel the transfer

without the consent of the counterparty

Irrevocable: after the payment has been sent and before

payment from the otherparty is due Uncertain: after the

payment from the other party is due but before it is actually

received

Settled: after the counterparty payment has been received

Failed: after it has been established that the counterparty has

not made the payment


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Settlement risk occurs during the periods of irrevocable

and uncertain status, which can take from one to three days.

While this type of credit risk can lead to substantial

economic losses, the short nature of settlement risk makes it

fundamentally different from presettlement risk. Managing

settlement risk requires unique tools, such as real-time gross

settlement (RTGS) systems. These systems aim at reducing

the time interval between the time an institution can no

longer stop a payment and the receipt of the funds from thecounterparty.Settlement risk can be further managed with

netting agreements. One such form is bilateral netting, which

involves two banks. Instead of making payments of gross

amounts to each other, the banks would tot up the balance

and settle only the net balance outstanding in each currency.

At the level of instruments, netting also occurs with contracts

for differences (CFD). Instead of exchanging principals in

different currencies, the contracts are settled in dollars at the

end of the contract term.2

The next step up is a multilateral netting system, also called

continuous-linked settlements, where payments are netted

for a group of banks that belong to the system. This idea

became reality when the CLS Bank, established in 1998

with 60 bank participants, became operational on September

9, 2002. Every evening, CLS Bank provides a schedule of

payments for the member banks to follow during the next

day.


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Chapter4 : Overview of Credit Risk

4.1 Drivers of Credit Risk

We now examine the drivers of credit risk, traditionally

defined as presettlement risk. Credit risk measurement

systems attempts to quantify the risk of losses due to coun-

terparty default. The distribution of credit risk can be viewed

as a compound process

driven by these variables

Default, which is a discrete state for the counterpartyeither

the counterparty is in default or not. This occurs with some

probability of default (PD).

Credit exposure (CE), also known as exposure at default

(EAD), which is the economic value of the claim on the

counterparty at the time of default.

Loss given default (LGD), which represents the fractional

loss due to default. As an example, take a situation where

default results in a fractional recovery rate of

30% only. LGD is then 70% of the exposure.

Traditionally, credit risk has been measured in the context of

loans or bonds for which the exposure, or economic value,

of the asset is close to its notional, or face value. This is an

acceptable approximation for bonds but certainly not for

derivatives, which can have positive or negative value.

Credit exposure is defined as the positive


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value of the asset:

Credit Exposuret = Max(Vt, 0)

This is so because if the counterparty defaults with money

owed to it, the full amount has to be paid.3 In contrast, if it

owes money, only a fraction may be recovered. Thus,

presettlement risk only arises when the contracts

replacement cost has a positive value to the institution (i.e.,

is in-the-money).

Measurement of Credit Risk

The evolution of credit risk management tools has gone

through these steps:

Notional amounts

Risk-weighted amounts External/internal credit ratings

Internal portfolio credit models

Initially, risk was measured by the total notional amount. A

multiplier, say 8 per- cent, was applied to this amount to

establish the amount of required capital to hold as a reserve

against credit risk.

The problem with this approach is that it ignores variations

in the probability of default. In 1988, the Basel Committee

instituted a very rough categorization of credit risk by risk-

class, providing risk weights to scale each notional amount.

This was the first attempt to force banks to carry enough

capital in relation to the risks they were taking.


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These risk weights proved to be too simplistic, however,

creating incentives for banks to alter their portfolio in order

to maximize their shareholder returns subject to the Basel

capital requirements. This had the perverse effect of creating

more risk into the balance sheets of commercial banks,

which was certainly not the intended purpose of the 1988

rules. As an example, there was no difference between AAA rated

and c rated credits. Since loans to C-credits are more profitable

than those to AAA-credits, given the same amount of

regulatory capital, the banking sector responded by shifting

its loan mix toward lower-rated credits.

This led to the 2001 proposal by the Basel Committee to

allow banks to use their own internal or external credit

ratings. These credit ratings provide a better represen- tation

of credit risk, where betteris defined as more in line with

economic measures. The new proposals will be described in

more detail in a following chapter.

Even with these improvements, credit risk is still measured on

a stand-alone basis. This harks back to the ages of finance

before the benefits of diversification were for- malized by

Markowitz. One would have to hope that eventually the

banking system

will be given proper incentives to diversify its credit risk.


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4.2 Credit Risk vs. Market Risk

The tools recently developed to measure market risk have

proved invaluable to assess credit risk. Even so, there are a

number of major differences between market and

credit risks .As mentioned previously, credit risk results from

a compound process with three sources of risk. The nature of

this risk creates a distribution that is strongly skewed to the

left, unlike most market risk factors. This is because credit

risk is akin to short positions in options. At best, the

counterparty makes the required payment and there is no loss.

At worst, the entire amount due is lost.

The time horizon is also different. Whereas the time required

for corrective action is relatively short in the case of market

risk, it is much longer for credit risk. Positions

also turn over much more slowly for credit risk than for

market risk, although the advent of credit derivatives now

makes it easier to hedge credit risk.

Finally, the level of aggregation is different. Limits on

market risk may apply at the level of a trading desk, business

units, and eventually the whole firm. In contrast, limits on

credit risk must be defined at the counterparty level, for all

positions taken by the institution.

Credit risk can also mix with market risk. Movements in

corporate bond prices indeed reflect changing expectations

of credit losses. In this case, it is not so clear


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whether this volatility should be classified into market risk

or credit risk.


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Chapter 5: Credit Risk Management by Stock

Exchange.

5.1 Settlement Process at NSCCL

The settlement process begins as soon as members'

obligations are determined through the clearing process. The

settlement process revolves around the clearing corporation,

which with the help of clearing banks and depositories, with

clearing corporation providing a major link between clearing

banks and depositories ensures actual movement of funds as

well as securities on the prescribed pay-in and pay-out day.

This requires members to bring in their funds/securities to

the clearing corporation. The CMs make the securities

available in designated accounts with the two dep ositories

(CM pool account in the case of NSDL and designated

settlement accounts in the case of CDSL). The depositories

move

the securities available in the pool accounts to

pool account of the clearing corporation. Likewise C Ms

with funds obligations make funds available in the

designated accounts with clearing banks. The clearing

corporation sends electronic instructions to the clearing

banks to debit designated CMs' accounts to the extent of

payment obligations. The banks process these instructions,

debit accounts of CMs and credit accounts of the clearing

corporation. This constitutes pay-in of funds and of


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securities.

After processing for shortages of funds/securities and

arranging for movement of funds from surplus banks t o

deficit banks through RBI clearing, the clearing corporation

sends electronic instructions to the depositories/clearing

banks to release pay-out of securities/funds. The depositories

and clearing banks debit accounts of the Clearing

Corporation and credit accounts of CMs. This constitutes

pay out of funds and securities.

Settlement is deemed to be complete upon declaration and

release of pay-out of funds and securities. The settlement is

performed by NSCCL as per well-defined settlement cycle.

5.2 Settlement Guarantee Mechanism

NSCCL has adopted the principle of novation for

settlement of all trades. It is the legal counter-party to the

settlement obligations of every member. NSCCL carries out

the clearing and settlement of the trades executed in the

Equities and Derivatives segments and operates Subsidiary

General Ledger (SGL) for settlement of trades in

government securities. It assumes the counter-party risk of

each member and guarantees financial settlement. It also

undertakes settlement of transactions on other stock

exchanges like, the Over the Counter Exchange of India.

NSCCL meets all settlement obligations, regardless of

member complying with his obligations, without any


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discretion. Once a member fails on any obligations, NSCCL

immediately initiates measures to reduce exposure limits,

withhold pay out of securities, square up open positions,

disable trading terminal until members obligations are fully

discharged.

NSCCL assumes the counter party risk of each member and

guarantees financial settlement. Counter party risk is

guaranteed through a fine tuned risk management system

and an innovative method of on -line position monitoring andautomatic disablement. A large Settlement Guarantee Fund

provides the cushion for any residual risk. In the event of

failure of a trading member to meet settlement obligations or

committing default, the Fund is utilized to the extent

required for successful completion of the settlement. This

has eliminated counter party risk of trading on the Exchange.

The market has now full confidence that settlements will

take place in time and will be completed irrespective of

possible default by isolated trading members. The

5.3 Equities Segment

Members are required to provide liquid assets which

adequately cover various margins & base minimum capital

requirements. Liquid assets of the member include their

Initial membership deposits including the security deposits.

Members may provide additional collateral deposit towards

liquid assets, over and above their minimum membership


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NSCCL at all points of time, after activation.

Every CM is required to maintain BMC of Rs.50 lakh with

NSCCL in the following manner:

Rs. 25 lakh in the form of cash.

Rs.25 lakh in any one form or combination of the following

forms: (a) cash (b) fixed deposit receipts with approved

custodians ban Guarantee from approved banks (d) approved

securities in demat form deposited with approved custodians

In addition to the above minimum base capital requirements,

every CM is required to maintain BMC of Rs.10 lakh, in

respect of every trading member(TM) whose deals such CM

undertakes to clear and settle, in the following manner:

Rs. 2 lakh in the form of cash.

Rs.8 lakh in a one form or combination of the following: (a)

cash (b) fixed deposit receipts with approved custodians (c)

Bank Guarantee from approved banks (d) approved

securities in demat form deposited with approved custodians

Any failure on the part of a CM to meet with the BMC

requirements at any point of time, will be treated as a

violation of the Rules, Bye-Laws and Regulations ofNSCCL and would attract disciplinary action inter-alia

including, withdrawal of trading facility and/or clearing

facility, closing out of outstanding positions etc.Additional

Base Capital


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Clearing members may provide additional margin/collateral

deposit (additional base capital) to NSCCL and/or may wish

to retain deposits and/or such amounts which are receivable

from NSCCL, over and above their minimum deposit

requirements, towards initial margin and/or other

obligations.

Clearing members may submit such deposits in any one

form or combination of the following forms: (i) Cash (ii)

Fixed Deposit Receipts with approved custodians (iii) BankGuarantee from approved banks (iv) approved securities in

demat form deposited with approved custodians.

5.5 Effective Deposits / Liquid Networth

Effective deposits

All collateral deposits made by CMs are segregated into cash

component and non-cash component.

For Additional Base Capital, cash component means cash,

bank guarantee, fixed deposit receipts, T-bills and dated

government securities. Non-cash component shall mean all

forms of collateral deposits like deposit of approved demand

securities.

At least 50% of the Effective Deposits should

in the form of cash.

Liquid Networth

Liquid Networth is computed by reducing the initial margin


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payable at any point in time from the effective deposits.

The Liquid Networth maintained by CMs at any point in

time should not be less than Rs.50 lakh (referred to as

Minimum Liquid Net Worth).


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Chapter6 :Margins

6.1Equities Segment

As per SEBI directives, the stocks are categorized as follows

for imposition of margins:

The Stocks which have traded atleast 80% of the days for the

previous six months shall constitute the Group I (Liquid

Securities) and Group II (Less Liquid Securities).

Out of the scrips identified above, the scrips having mean

impact cost of less than or equal to 1% shall be categorized

under Group I and the scrips where the impact cost is more

than 1, shall be categorized under Group II.

The remaining stocks shall be classified into Group III

(Illiquid Securities).

The impact cost shall be calculated on the 15th of each

month on a rolling basis considering the order book

snapshots of the previous six months. On the basis of the

impact cost so calculated, the scrips shall

move from one group to another group from the 1st of the

next month.

For securities that have been listed for less than six months,

the trading frequency and the impact cost shall be computed

using the entire trading history of the security.

For the first month and till the time of monthly review a

newly listed security shall be categorised in that Group


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where the market capitalization of the newly listed security

exceeds or equals the market capitalization of 80% of the

securities in that particular group. Subsequently, after one

month, whenever the next monthly review is

carried out, the actual trading frequency and impact cost of

the security shall be computed, to determine the liquidity

categorization of the security.

In case any corporate action results in a change in ISIN, then

the securities bearing the new ISIN shall be treated as newly

listed security for group categorization

6.2 Margin requirement

yValue at Risk MarginyExtreme Loss MarginyMark-To-Market Margin

Daily margin, comprising of the sum of VaR margin,

Extreme Loss Margin and mark to market margin is payable.

Value at Risk Margin

VaR Margin is a margin intended to cover the largest loss

that can be encountered on 99% of the days (99% Value at

Risk). For liquid securities, the margin covers one-day losses

while for illiquid securities, it covers three-day losses so as

to allow the clearing corporation to liquidate the position


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over three days. This leads to a scaling factor of square root

of three for illiquid securities.

For liquid securities, the VaR margins are based only on the

volatility of the security while for other securities, the

volatility of the market index is also used in the

computation.

Computation of VaR Rate:

VaR is a single number, which encapsulates whole

information about the risk in a portfolio. It measures

potential loss from an unlikely adverse event in a normal

market environment. It involves using historical data on

market prices and rates, the current portfolio positions, and

models (e.g., option models, bond models) for pricing those

positions. These inputs are then combined in different ways,

depending on the method, to derive an estimate of aparticular percentile of the loss distribution, typically the

99th percentile loss.

The return is defined as the logarithmic return: rt = ln(It/It -

1 ) where It is the index futures price at time t.

Security sigma means the volatility of the security computed

as at the end of the previous trading day. The volatility is

computed as mentioned above

Security VaRmeans the higher of 7.5% or 3.5 security

sigmas.


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Index sigma means the daily volatility of the market index

(S&P CNX Nifty or BSE Sensex) computed as at the end of

the previous trading day.

Index VaR means the higher of 5% or 3 index sigmas. The

higher of the Sensex VaR or Nifty VaR would be used for

this purpose.

The VaR Margins are specified as follows for different

groups of securities:

Liquidity One-Day VaR Scaling factor for VaR Margin

Categorization illiquidity

Liquid Securities Security VaR 1.00 Security VaR

(Group I)

Less Liquid Higher of Security 1.73 Higher of 1.73

Securities VaR and three (square root of times Security

(Group II) times Index VaR 3.00) VaR and 5.20

times Index VaR

Illiquid Securities Five times Index 1.73 8.66 times Index

(Group III) VaR (square root of VaR

3.00)

In case of securities in Trade for Trade segment (TFT

segment) the VaR rate applicable is 100%.

VaR margin rate for a security constitutes the

following:


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Value at Risk (VaR) based margin, which is arrived at, based

on the methods stated above. The index VaR, for the

purpose, would be the higher of the daily Index VaR based

on S&P CNX NIFTY or BSE SENSEX. The index VaR

would be subject to a minimum of 5%.

Security specific Margin: NSCCL may stipulate security

specific margins for the securities from time to time.

The VaR margin rate computed as mentioned above will be

charged on the net outstanding position (buy value-sell

value) of the respective clients on the respective securities

across all open settlements. There would be no netting off of

positions across different settlements. The net position at a

client level

for a member are arrived at and thereafter, it is grossed

across all the clients including proprietary position to arriveat the gross open position.

For example, in case of a member, if client A has a buy

position of 1000 in a security and client B has a sell position

of 1000 in the same security, the net position of the member

in the security would be taken as 2000. The buy position of

client A and sell position of client B in the same security

would not be netted. It would be summed up to arrive at the

members open position for the purpose of margin

calculation.

The VaR margin shall be collected on an upfront basis by


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adjusting against the total liquid assets of the member at the

time of trade.

The VaR margin so collected shall be released on

completion of pay-in of the settlement.

Extreme Loss Margin

The Extreme Loss Margin for any security shall be

higher of:5%, or 1.5 times the standard deviation of daily

logarithmic returns of the security price in the last six

months. This computation shall be done at the end of each

month by taking the price data on a rolling basis for the pa st

six months and the resulting value shall be applicable for the

next month. In view of market volatility, SEBI may direct

stock exchanges to change the margins from time -to-time in

order to ensure market safety and safeguard the interest of

investors.The Extreme Loss Margin shall be collected/adjusted against the total liquid assets of the member on a

real time basis.The Extreme Loss Margin shall be collected

on the gross open position of the member. The gross open

position for this purpose would mean th e gross of all net

positions across all the clients of a member including its

proprietary position.

There would be no netting off of positions across different

settlements. The Extreme Loss Margin collected shall be

released on completion of pay-in of the settlement.


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Mark-to-Market Margin

Mark to market loss shall be calculated by marking each

transaction in security to the closing price of the security at

the end of trading. In case the security has not been traded

on a particular day, the latest available closing price at the

NSE shall be considered as the closing price. In case the net

outstanding position in any security is nil, the difference

between the buy and sell values shall be considered as

notional loss for the purpose of calculating the mark-to-market margin payable.

MTM Profit/Loss = [(Total Buy Qty X Close price) Total

Buy Value] - [Total Sale Value - (Total Sale Qty X Close

price)]

The mark to market margin (MTM) shall be collected from

the member before the start of the trading of the next day.

The MTM margin shall also be collected/adjusted

from/against the cash/cash equivalent component of the

liquid net worth deposited with the Exchange.

Example 1:

A trading member has two clients with the following MTM

positions. What will be the MTM for the trading me mber?


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Client Security X Security Y Security Z

T-1 Day T Day T-1 Day T Day T-1 Day T Day

A 800 300 -500 -1200 0 0

B 1000 500 0 0 -1500 -800

The MTM for the trading member will be -1700.

The MTM margin shall be collected on the gross open

position of the member. The gross open position for this

purpose would mean the gross of all net positions across all

the clients of a member including its proprietary position.

For this purpose, the position of a client would b e netted

across its various securities and the positions of all the

clients of a broker would be grossed.

There would be no netting off of the positions and setoff

against MTM profits across two rolling settlements i.e. T

day and T-1 day. However, for computation of MTM

profits/losses for the day, netting or setoff against MTM

profits would be permit Example 2:A trading member has

two clients with the following positions. What will be the

gross open position for the member in X, Y and Z?


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Client Security Settlement Buy Value Sell Value

Client

A Security X 2005001 1000 1100

Security Y 2005002 3000 2550

Client

B Security X 2005001 4500 2400

Security Z 2005002 7000 10450

The gross open position for the member in X, Y & Z will be

2200, 450, 3450 respectively.

In case of Trade for Trade Segment (TFT segment) each

trade shall be marked to market based on the closing price of

that security.

The MTM margin so collected shall be released on

completion of pay-in of the settlement.

6.3Margin short foll

In case of any shortfall in margin:

The members shall not be permitted to trade withimmediate effect.

A penalty of Rs.5000/- will be levied for violation of margin

which shall be paid by next day. In case of subsequent

violations during the day, penalty shall be increased by


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Rs.5000/- for each such instance. (For example in case of

second violation for the day the penalty levied will be

Rs.10000/-, Rs.15000/- for third instances and so on).The

penalty will be debited to the clearing account of the

member.

Penal charge of 0.07% per day shall be levied on the amount

of margin shortage throughout the period of non -payment.

6.4Exemption from margins:

Institutional businesses i.e., transactions done by all

institutional investors shall be exempt from margin

payments. For this purpose, institutional investors shall

include:

Foreign Institutional Investors registered with SEBI(FII).

Mutual Funds registered with SEBI (MF).

Public Financial Institutions as defined under Section 4A of

the Companies Act, 1956 (DFI).

Banks, i.e., a banking company as defined under Section

5(1)(c) of the Banking Regulations Act, 1949 (BNK).

In cases where early pay-in of securities is made prior

to the securities

pay-in, such positions for which early pay-in (EPI) of


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securities is made shall be exempt from margins. The EPI

would be allocated to clients having net deliverable position,

on a random basis. However, members shall ensure to pass

on appropriate early pay-in benefit of margin to the relevant

clients.

6.5Derivatives Segment

NSCCL has developed a comprehensive risk containment

mechanism for the Futures & Options segment. The most

critical component of a risk containment mechanism for

NSCCL is the online position monitoring and margining

system. The actual margining and position monitoring is

done on-line, on an intra-day basis. NSCCL uses the SPAN

(Standard Portfolio Analysis of Risk) system for the purpose

of margining, which is a portfolio based system.

The objective of SPAN is to identify overall risk in aportfolio of futures and options contracts for each member.

The system treats futures and options contracts uniformly,

while at the same time recognizing the unique exposures

associated with options portfolios like extremely deep out-

of-the-money short positions, inter- month risk and inter-

commodity risk.

SPAN is used to determine performance bond requirements

(margin requirements), its overriding objective is to

determine the largest loss that a portfolio might reasonably

be expected to suffer from one day to the next day.


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SPAN constructs scenarios of probable changes in

underlying prices and volatilities in order to identify the

largest loss a portfolio might suffer from one day to the next.

It then sets the margin requirement at a level sufficient to

cover this one-day loss.

6.6Initial Margin

NSCCL collects initial margin up-front for all the open

positions of a CM based on the margins computed by

NSCCL-SPAN. A CM is in turn required to collect the

initial margin from the TMs and his respective clients.

Similarly, a TM should collect upfront margins from his

clients.

Initial margin requirements are based on 99% value at risk

over a one day time horizon. However, in the case of futures

contracts (on index or individual securities), where it maynot be possible to collect mark to market settlement value,

before the commencement of trading on the next day, the

initial

margin may be computed over a two-day time horizon,

applying the appropriate statistical formula. The

methodology for computation of Value at Risk percentage is

as per the recommendations of SEBI from time to time.

6.7Premium Margin

In addition to Initial Margin, Premium Margin would be

charged to members. The premium margin is the client wise


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margin amount payable for the day and will be required to

be paid by the buyer till the premium settlement is complete.

6.8Assignment Margin

Assignment Margin is levied on a CM in addition to SPAN

margin and Premium Margin. It is required to be paid on

assigned positions of CMs towards Interim and Final

Exercise Settlement obligations for option contracts on

individual securities and index, till such obligations are

fulfilled.

The margin is charged on the Net Exercise Settlement Value

payable by a Clearing Member towards Interim and Final

Exercise Settlement and is deductible from the effective

deposits of the Clearing Member available towards margins.

Assignment margin is released to the CMs for exercise

settlement pay-in.

6.9Payment of Margins ;The initial margin is payable

upfront by Clearing Members. Initial margins can be paid by

members in the form of Cash, Bank Guarantee, Fixed

Deposit Receipts and approved securities.

Non-fulfillment of either the whole or part of the margin

obligations will be treated as a violation of the Rules, Bye-

Laws and Regulations of NSCCL and will attract penal

charges @ 0.07% per day of the amount not paid throughout

the period of non-payment. In addition NSCCL may at its

discretion and without any further notice to the clearing


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member, initiate other displinary action, inter-alia including,

withdrawal of trading facilities and/ or clearing facility,

close out of outstanding positions, imposing penalties,

collecting appropriate deposits, invoking bank guarantees/

fixed deposit receipts, etc.

6.10Violations

PRISM (Parallel Risk Management System) is the real-time

position monitoring and risk management system for the

Futures and Options market segment at NSCCL. The risk of

each trading and clearing member is monitored on a real -

time basis and alerts/disablement messages are generated if

the member crosses the set limits.

yInitial Margin ViolationyExposure Limit Violation

Trading Memberwise Position Limit Violation

Client Level Position Limit Violation

Market Wide Position Limit Violation

Violation arising out of misutilisation of trading member/

constituent collaterals and/or deposits

Violation of Exercised Positions

Clearing members, who have violated any requirement and /

or limits, may submit a written request to NSCCL to either

reduce their open position or, bring in additional cash


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deposit by way of cash or bank guarantee or FDR or

securities.

A penalty of Rs. 5000/- is levied for each violation and is

debited to the clearing account of clearing member on the

next business day. In respect of violation on more than one

occasion on the same day, penalty in case of second and

subsequent violation during the day wil l be increased by

Rs.5000/- for each such instance. (For example in case of

second violation for the day the penalty leviable will beRs.10000/-, Rs.15000 for third instance and so on). The

penalty is charged to the clearing member irrespective of

whether the clearing member brings in margin deposits

subsequently.

Where the penalty levied on a clearing member/ trading

member relates to a violation of Client-wise Position Limit,

the clearing member/ trading member may in turn, recover

such amount of penalty from the concerned clients who

committed the violation

Market Wide Position Limits for derivative contracts on

underlying stocks

At the end of each day the Exchange shall test whether the

market wide open interest for any scrip exceeds 95% of the

market wide position limit for that scrip. If so, the Exchange

shall take note of open position of all client/ TMs as at the

end of that day in that scrip, and from next day onwards the

client/ TMs shall trade only to decrease their positions


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through offsetting positions till the normal trading in the

scrip is resumed.

The normal trading in the scrip shall be resumed only after

the open outstanding position comes down to 80% or below

of the market wide position limit.

A facility is available on the trading system to display an

alert once the open interest in the futures and options

contract in a security exceeds 60% of the

market wide position limits specified for such security. Such

alerts are presently displayed at time intervals of 10 minutes.

At the end of each day during which the ban on fresh

positions is in force for any scrip, when any member or

client has increased his existing positions or has created a

new position in that scrip the client/ TMs shall be subject to

a penalty of 1% of the value of increased p osition subject to

a minimum of Rs.5000 and maximum of Rs.1,00,000. The

positions, for this purpose, will be valued at the underlying

close price.

The penalty shall be recovered from the clearing member

affiliated with such trading members/clients on a T+1 day

basis along with pay-in. The amount of penalty shall be

informed to the clearing member at the end of the day


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Chapter 7 :Credit Default Swaps

1. Credit Default Swaps (CDS) are a class of credit

derivatives that can be used to transfer credit risk from the

investor exposed to the risk (the protection buyer) to an

investor willing to assume that risk (the protection seller).

While dealing in CDS, both buyer and seller of credit

protection specify a reference entity, reference obligation,

maturity of the contract, notional amount, credit events, etc.

2. CDSis a bilateral derivative contract on one or more

reference assets in which the protection buyer pays a

premium through the life of the contract in return for a credit

event paymentby the protection seller following a credit

eventof the reference entities. In most instances, the

protection buyer makes quarterly payments to the protection

seller. The periodic payment (premium) is typically

expressed in annualised basis points of a transactions

notional amount. If any one of the credit events occurs

during the life of the contract, the protection buyer will

receive from the protection seller, a credit event payment,

which will depend upon whether the terms of a particular

CDS call for a physical or cash settlement. Generally, the

legal framework of CDS i.e., 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). If a credit


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event occurs, the contract is settled through one of the types

of settlement specified in the contract.

3. In option terminology, the CDS protection buyer (long

put) is short the credit risk and pays the premium or CDS

spread to the protection seller (short put) who is long the

credit risk. If there is no credit event by the contract

expiration date, the protection buyer loses the premiums

paid. On the other hand, if there is a credit event during the

term of the contract, the protection seller will make a

contingent payment to the protection buyer. Thus, procedure

following the credit event is analogous to exercising an in -

the money put option.

4 Credit default swaps can be conceptualised as a piece

of a debt obligation consisting of the credit spread (i.e., the

interest beyond the risk-free rate) and the default risk of the

instrument, both of which are transferred to the protection

seller. A hedge buyer of a credit default swap essentially

transforms part or all of his existing exposure on a debt

obligation into something close to a high-quality government

bond the "closeness" varying with the credit risks

associated with the counterparty to the swap. Conversely, the

seller of a credit default swap buys a slice of the original

debt obligation, taking on the role of a lender but without

incurring any funding costs or interest rate risks. The seller

has acquired an instrument that will turn almost entirely on


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the firm-specific risks of the reference debtor. [Lubben,

2007]

5 CDS andCredit Guarantee: The credit default swap

structure is very close to that of a guarantee but differs in

three important ways: the range of credit events that trigger

payment is much broader under CDS; the protection buyer is

not required to prove that it itself had suffered a loss, in

order to receive payment; and CDSs are based onstandardised documentation and are traded. Credit default

swaps are traditionally traded over-the-counter (OTC), rather

than on an exchange. These are customised risk transfer

instruments that are negotiated and executed bilaterally

between counterparties. CDS counterparties typically post

collateral to guarantee that they will fulfill their obligations.

Post-crisis, the regulators and market participants are

moving towards centralised clearing of these instruments.

6 Single Name, Index and BasketCDS: There are three

types of CDS. First, the single-name CDS offers protection

for a single corporate or sovereign reference entity. Second,

CDS indices are contracts which consist of a pool of single-

name CDSs, whereby each entity has an equal share of the

notional amount within the index. The standardization and

transparency of indices has contributed strongly to the

growth of index contracts. Third, basket CDS is a CDS on a


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portfolio with many reference entities. The payoff trigger

can be the first default (1 st-to-default), the second default

(2nd-to-default) or the nth default (nth-to-default).

7 The features of a credit default swap are:

(i) Reference Entity: CDS generally references to thecredit quality of the issuer and not the obligation.

Credit default swap contracts specify a reference

obligation (a specific bond or loan) which defines the

issuing entity through the bond prospectus. Following

a credit event, bonds or loans pari passu with the

reference entity bond or loan are deliverable into the

contract. Typically a senior unsecured bond is the

reference obligation, but bonds at other levels of the

capital structure may be referenced.

(ii) Notional amount: The amount of credit risk beingtransferred. This amount is agreed between the buyer

and seller of CDS protection.

(iii) Spread: The payments (cost of CDS to the buyer)quoted in basis points paid annually. Payments are

paid quarterly, and accrue on an actual/360 day basis.

The spread is also called the fixed rate, coupon, or

price.(iv) Maturity: The expiration of the contract, usually on

the 20th of March, June, September or December in

case of standardised contracts.


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8 Credit Events: A credit event is a pre-specified event

that triggers a contingent payment on a credit default swap.

Credit events are defined in the 2003 ISDA Credit

Derivatives Definitions and include the following:

(i) Bankruptcy: includes insolvency, appointment ofadministrators/liquidators, and creditor arrangements.

(ii) Failure to pay: includes payment failure on one ormore obligations after expiration of any applicable

grace period; typically subject to a materialitythreshold (e.g., USD 1million for North American

CDS contracts).

(iii) Restructuring: refers to a change in the agreementbetween the reference entity and the holders of an

obligation (such agreement was not previously

provided for under the terms of that obligation) due to

the deterioration in creditworthiness or financial

condition to the reference entity with respect to

reduction of interest or principal / postponement of

payment of interest or principal.

(iv) Repudiation/moratorium: authorised governmentauthority (or reference entity) repudiates or imposes

moratorium and failure to pay or restructuring occurs.

(v) Obligation acceleration: one or more obligations havebecome due and payable before they would otherwise

have been due and payable as a result of, or on the

basis of, the occurrence of a default, event of default

or other similar condition or event (however


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described), other than a failure to make any required

payment, in respect of a Reference Entity under one or

more Obligations in an aggregate amount of not less

than the Default Requirement.

(vi) Obligation Default: one or more obligations havebecome capable of being declared due and payable

before they would otherwise become due and payable

as a result of, or on the basis of, the occurrence of a

default, event of default, or other similar condition or

event (however described), other than a failure to

make any required payment, in respect of a reference

entity under one or more obligations in an aggregate

amount of not less than the default requirement.

However, recently in the US market restructuring has been

excluded from credit events. Further, there are several

versions of the restructuring credit event that are used in

different markets (e.g. modified restructuring in the Euro

zone).

9 Monetising the CDS: It is not necessary that a credit

event must occur to enable credit default swap investors to

capture gains or losses. Credit default swap spreads widenwhen the market perceives credit risk has increased and

tightens when the market perceives credit risk has improved.

Investors could monetise unrealised profits using two

methods. First, investor could enter into the opposite trade,


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selling/ buying protection for effectively locking in profits

till contract maturity. The second method to monetise trades

is to unwind them with another investor and receive the

present value of the expected future payments.


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Chapter 8 :on-line Monitoring

NSCCL has in place an on-line position monitoring and

surveillance system whereby positions of the members is

monitored on a real time basis. A system of alerts has been

built in so that both the member and NSCCL are alerted

when the margins of a member approaches pre -set levels

(70%, 85%, 90%, 95% and 100%). The system also allows

NSCCL to further check the micro-details of members

positions, if required.

This facilitates NSCCL to take pro-active action. NSCCL

has discretion to initiate action suo moto for reducing a

member position, if required, more particularly where a

member, after NSCCL requiring him to reduce his position

fails to close out positions or make additional margin calls.

The on-line surveillance mechanism also generates various

alerts/reports on any price/volume movement of securities

not in line with past trends/patterns. For this pur pose the

exchange maintains various databases to generate alerts.

Alerts are scrutinized and if necessary taken up for follow up

action. Open positions of securities are also analysed.

Besides this, rumors in the print media are tracked and

where they are price sensitive, companies are contacted for

verification. Replies


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yCase StudyCredit Default Swap

Although swaps can be used to hedge against any sort of credit risk, they

are easiest to explain through a notional case study of an instrument such

as a bond. A fund may, for example, hold $8,000,000 of Mega Car

Companys five-year bond, and is concerned about the possibility of

default due to market conditions arising from rising oil prices, increased

government regulation on emissions, or the macroeconomic climate.

The fund decides to buy a credit default swap in a notional amount of

$8,000,000 to cover the potential default value. The CDS in this case

trades at 150 basis points, so the fund will pay 1.5% of $8,000,000, or

$120,000 annually.

If Mega Car Company does not default, the fund will simply receive the

full $8,000,000. In this case its return will not be as good as it would have

been without the CDS.

On the other hand, if the corporation does default after, say, two years,

the fund will receive its $8,000,000 from the seller of the CDS. It could

be that the seller will take the bond or pay the difference between the

recovery value and the par value of the bond.

Alternatively, Mega Car Company could make a breakthrough in low -

emission technology and dramatically improve its credit profile. In that

case the fund might decide to reduce its outgoings by selling the

remaining period of the CDS.


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Back to top

Advantages

y Derivatives such as a CDS will reduce or entirely remove the riskof default.

Back to top

Disadvantages

y The cost of hedging will reduce the return on investment.

Credit Risk Management at JP Morgan Chase

JP Morgan Chase (JP), the second largest financial services company in

the US, is exposed to credit risk through its lending, trading and capital

market activities. JP''s credit risk management practices are designed to

preserve the independence and integrity of the risk assessment process. JP

has taken various steps to ensure that credit risks are adequately assessed,

monitored and managed. In early 2003, JP has combined its Credit Risk

Policy and Global Credit Management functions to form Global Credit

Risk Management consisting of the five primary functions - Credit Risk

Management, Credit Portfolio Group, Policy & Strategic Group, Special

Credits Group and Chase Financial Services (CFS) Consumer Credit

Management Risk. JP Morgan Chase (JP) was exposed to credit riskthrough its lending, trading and capital market activities. JP's credit risk

management (CRM)1 practices were designed to preserve the

independence and integrity of the risk assessment process. JP had taken

various steps to ensure that credit risks were adequately assessed,


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monitored and managed.

In early 2003, the Credit Risk Policy and Global Cr edit Management

functions were combined to form Global CRM consisting of the five

primary functions Credit Risk Management, Credit Portfolio Group,

Policy & Strategic Group, Special Credits Group and Chase Financial

Services (CFS) Consumer Credit Management Risk. (See Exhi Consumer

Credit Management Risk. (See Exhibit 6).

Business Strategy & Risk Management

Commercial

JP's business strategy for its large corporate commercial portfolio

remained primarily one of origination for distribution. Bulk of the

wholesale loan originations were distributed into the marketplace.

Residual holds averaged less than 10%. The commercial loan portfolio

declined by 9% in 2003, due to a combination of continued weak loan

demand, ongoing goal of reducing commercial credit co ncentrations and

refinancings into more liquid capital markets.

To measure commercial credit risk, JP estimated the likelihood of default;

the amount of exposure in case of default and the loss severity given a

default event. Based on these factors and r elated market-based inputs, JP

estimated both expected and unexpected losses for each segment of the

portfolio. Expected losses were statistically based estimates of credit

losses over time.


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They were used to set risk-adjusted credit loss provisions. Such losses

could be factored into the pricing and covered as a normal and recurring

cost of doing business. Unexpected losses represented the potential

volatility of actual losses relative to the expected level of losses and

formed the basis for the credit risk capital-allocation process...

Commercial and Consumer Credit Portfolio

JP's total credit exposure was $730.9 billion as on 31st December 2003

(Exhibit 9), a 2% increase when compared to 2002. The increase reflected

a $41.5 billion in consumer exposure, partially offset by a $30.2 billion

decrease in commercial exposure...

Commercial Credit Portfolio

As on 31st December 2003, 83% of the total commercial credit exposure

of $383 billion (See Exhibit 9) was considered investment -grade, an

improvement from 80% in 2002...

Consumer Credit Portfolio

Consumer portfolio's largest component consisted primarily of 14

family residential mortgages, credit cards and automobile financings. The

consumer portfolio was predominantly US-based. 14 family residential

mortgage loans were primarily secured by first mortgages...


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Documents

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