Essay About Credit Derivatives And Credit-Linked Note

Credit Derivatives in India
What are Credit Derivatives?     “Credit derivatives can be defined as arrangement that allow one party to transfer credit risk to one or more other parties”Terms associated with credit derivatives Protection  Buyer : Party that contract to transfer credit riskProtection Seller: Party that contracts to receive premium in return for assuming riskCredit event: Scenario agreed between the contracting parties that will trigger credit eventSettlement : The amount that is paid following a credit eventReference Entity : Entity upon whose credit the contract is basedCredit Derivative Products Credit default Swap Credit default optionTotal return swapCredit linked noteRepackaged notesCollateralized debt obligation Credit default swap Credit default swaps allow one party to “buy” protection from another party for losses that might be incurred as a result of default by a specified reference creditThe “buyer” of protection pays a premium for the protection, and the “seller” of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified “credit events.”    Credit default swap    Credit default option An option to buy protection (payer option) or sell protection (receiver option) as a credit default swap on a specific reference credit with a specific maturity. The option is usually European, exercisable only at one date in the future at a specific strike price defined as a coupon on the credit default swapThe option holder will have to pay a premium rate called the strike, made in a single upfront payment. In case the underlying credit does default, the option knocks out and becomes nullified or worthlessTotal Return Swap A Total Rate of Return Swap (Total Return Swap or TR Swap) is a bilateral financial contract designed to transfer risk between parties, but a TR Swap is importantly distinct from a Credit Swap in that it exchanges the total economic performance of a specified asset for another cash flowPayments between the parties to a TR Swap are based upon changes in the market valuation of a specific credit instrument, irrespective of whether a Credit Event has occurredCredit linked notes A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the note issuer to the investor.   The issuer receives the  issue price for each CLN from the investor and invests this in low-risk collateral.If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity’s debt.Credit linked notes Repackaged Notes A repackaged note means the note newly repacked using derivatives such as currency and interest rate swaps to make cash flows of secondary market notes more appealing to investors. Underlying notes (collateral notes) are transferred to an overseas SPC and new notes are issued backed by themCollateralized Debt Obligations A CDO is an ABS that is collateralized by a pool of debt obligationsExamples include:Corporate Bonds with ratings below investment gradeMBS and ABS (called structured financial products)Bond issues in emerging marketsCorporate Loans commercial banks Special situation loans and distressed debtA CDO has the following structure:One or more senior tranchesSeveral levels of mezzanine tranchesA subordinate tranche known as the equity tranche, to provide prepayment and credit protection to other tranchesHas preference/subordination structure (senior note/junior note, senior note/mezzanine note/junior note) as there are plural numbers of cash flows of numerous issues of collateral notes backing up CDOThe target rating is once set forth based on the results of issue structure analysis, and then the actual rating is determined after establishing excess collaterals and assessing credit enhancing measures consistent with such target rating RBI’s stance on CDS RBI has taken a cautious stance on CDS guidelines so that the product that brought down AIG does not repeat itself in India. Therefore there are stricter norms in placeThe protection can be sold against risks of a single issue. In the case of AIG, the protection was provided for an MBS representing thousands of unknown home loansThe protection can be bought by only those who hold the bonds unlike during the financial crisis when many investors bought protection betting on the default of a particular corporateRBI has severely restricted the number of parties that can offer or sell this productRBI Guidelines for CDS Eligibility for Market Makers Reference Entity and Obligations Pricing and Settlement Methodology Other Requirements The reference asset/obligation and the deliverable asset/obligation shall be to a resident and denominated in Indian Rupees; Obligations such as asset-backed securities/mortgage-backed securities, convertible bonds and bonds with call/put options shall not be permitted as reference and deliverable obligationsCDS cannot be written on interest receivables CDS shall not be written on securities with original maturity up to one year e.g., Commercial Papers (CPs), Certificate of Deposits (CDs) and Non-Convertible Debentures (NCDs) with original maturity up to one yearthe CDS contract must represent a direct claim on the  protection seller.Dealing in any structured financial product with CDS as one of the components shall not be permittedDealing in any derivative product where the CDS itself is an underlying shall not be permissibleIt needs to be ensured that CDS are not used to build up excessive leveraged exposuresCDS in India – Journey so far Global Experience RBI introduced CDS in the Indian market at the right time. It could draw upon the experience of the western world during the Financial Crisis of 2008 and incorporate important safeguards since the inception: Avoid complexity: Products like CDOs, ABS, MBS not allowedCurb Speculative activity: Users allowed to only hedge long positing in cash bondsRegulatory limits: Avoid excessive risk taking by putting limits like single name exposure, gross PV01 limitsStandardized contracts: Enable trade reporting; enable trde compression thereby reducing systemic risks on account of large number of open contractsRegulatory oversight: Mandatory reporting of trades on central platform; Regulator can monitor activity of participants and avoid any misuse/ large concentration of risk Central Clearing Counterparty: Important to avoid counterparty risk; Will be introduced when volumes pick up and viable to implement Applications of CDS in the Global Market Trading/ Market makingProduct StructuringHedging trading instrumentsActive portfolio/ asset managementManagement of economic capitalManagement of regulatory capitalManagement of individual credit lines 1st CDS in India (Case study) Completed on Dec 7, 2011 Between IDBI and ICICI bankProtection was sold on bonds issued by REC ltd. and India Railway Finance Corp. ltd.Combined total size INR 10 crores, according to CCIPremium paid was 90 basis point