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Introduction To Credit Derivatives

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What are Derivatives?

A financial contract that has its price derivedfrom, and depending upon, the price of anunderlying asset.

The underlying assets might be traded.

Types of Derivatives include, Swaps, Optionsand Futures for example.

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What are Credit Derivatives?

Credit derivatives are derivative instruments

that seek to trade in credit risks.

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What is Credit Risk ?

The risk that a counterparty to a financial

transaction will fail to fulfill their obligation.

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G rowth in Credit Derivatives

Source: BBA Credit Derivatives Report 2006

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Types of credit derivatives

Credit default swap

Credit spread option

Credit linked note

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What is Credit default swap?

Credit default swaps allow one party to "buy" protection from another party for losses that might beincurred as a result of default by a specified reference

credit (or credits).

The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to makea payment to compensate the buyer for losses incurredupon the occurrence of any one of several specified"credit events."

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E xample

Suppose Bank A buys a bond which issued by a SteelCompany.

To hedge the default of Steel Company

Bank A buys a credit default swap from InsuranceCompany C.

Bank A pays a fixed periodic payments to C, inexchange for default protection.

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E xhibitCredit Default Swap

Bank A Buyer Insurance Company C

Seller

Steel companyReference Asset

Contingent Payment OnCredit Event

Premium Fee

Credit Risk

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Credit Spread

The difference between the yield on the borrowers

debt (loan or bond) and the yield on thereferenced

benchmark such as G sec yield of the samematurity.

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Credit Derivatives MarketParticipants

Protection Seller Banks

NBFCsPrimary DealersInsurance Company

Mutual Funds

MF s and ICs , subject to approval from respective regulatory bodies

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F or the protection seller(the risk buyer)

Diversification Leveraged exposure to a particular credit Access to an asset which may not otherwise be

available to the risk buyer sourcing ability Increase yield

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Credit Derivatives Market Participants

Protection Buyer Banks

NBFCsPrimary DealersInsurance CompanyMutual Funds

Housing Finance CompaniesProvident FundsCorporate

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For the protection buyer

(the risk seller)

To transfer credit risk on an entitywithout transferring the underlying instrument

Regulatory benefit Reduction of specific concentrations portfolio

management

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Reference E ntity

The credit protection is sought against thedefault of reference entity.

Shall be a single legal resident entity. CDS can be written only on obligations of rated

entities, but no minimum rating needs to be

specified.

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nderlying Obligation Loans Bonds Asset Backed Securities Mortgage Backed Securities

In India it is proposed to introduce CDS onlyon corporate bonds

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Requirement of underlying in CDS CDS can be bought only o the extent of

underlying risk Shall not maintain CDS protection without

underlying bond Buyer can unwind the position with the original

counterparty

Users are not permitted to enter into anoffsetting contract

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Related Party Transaction

y Users and market makers would not be permitted to enter into CDS transactions havingtheir related parties either as counterparties or as reference entities

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Standardization

Coupon Coupon payment dates (quarterly)

It will help in moving towards a centralizedclearing process reducing counterparty risk

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Credit E vents Bankruptcy Failure to pay Repudiation/Moratorium Obligation acceleration Obligation Default

Restructuring may not be permitted as creditevent in initial stages

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Determination committee

Market participants and FIMMDA may formDC of dealers and investors

DC should resolve issues pertaining to creditevents, CDS auction, succession events, etc

At least 25% of members may be drawn fromusers

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Settlement methodologies

For users , physical settlement is mandatory For ma rket ma kers , any of the three settlement

methods physical, cash and auction can beopted as envisaged in CDS contract

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Pricing/Valuation methodologies

Appropriate and robust methodologies to be putin place for MTM on a daily basis

Validated by external modelers Contracts may be valued on a single model FIMMDA may come out with a daily CDS

curve

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Benefits of CDS

E ffective means of Hedging E nhanced investment universe Assessment of credit conditions Risk distribution Reduces borrowing costs and increases credit

supply

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Risks in CDS

Sudden increase in credit spreads High incidence of credit events Jump-to-Default risk Basis risk Counterparty Risk

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Thank you.