credit default swaps in india

8/18/2009Credit Default Swaps1

Credit Default Swaps

Praveen P. MishallMMS 2008-10

Welingkar Institute of Management Development & [email protected]

mailto:[email protected]�


Agenda

What are Derivatives? What are Credit Derivatives? What are Credit Default Swaps Subprime Crisis and its implications Role of CDS in Subprime Crisis CDS Auction CDS Data Sources Central Counterparty Settlement for CDS Credit Derivatives Market in India CDS and its settlement in India


Derivatives What are Derivatives?

– Derivatives are financial contracts, or financial instruments, whose prices are derived from the price of underlying.

Uses of Derivatives– Hedging– Speculation– Arbitrage

Types of Derivatives– OTC Derivatives– Exchange Traded

Derivatives

Derivatives Contract Types– Forward & Future– Options– Swaps

Risks with Derivatives– Large losses due to leverage– Counterparty risk– Large notional amounts– Complicated nature of

Derivatives Driving forces for growth

– Volatility in asset prices– Integration of national

market with international– Communication facilities– Risk Management Tools


OTC Derivatives Growth

“Blaming derivatives for financial losses is akin to blaming cars for drunken driving fatalities”Christopher L. Culp

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Credit Derivatives What are Credit Derivatives?

– Credit derivatives can be defined as arrangements that allow one party (protection buyer or originator) to transfer, for a premium, the defined credit risk, or all the credit risk, computed with reference to a notional value, of a reference asset or assets, which it may or may not own, to one or more other parties (the protection sellers).

Types of Credit Derivatives– Credit Default Swap– Total Return Swap– Credit linked notes– Credit spread option

Credit Derivatives Risks– Credit Risk– Market Risk– Legal Risk

Driving forces for growth– Securitization– Index products– Tranching (slicing in French)

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Credit Default Swap What is Credit Default Swap?

– A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.

General Characteristics– Quarterly CDS premium

(spread) payment– Spread inversely related

to quality of underlying– Standard range for deals

$10-20 million– Standard maturity of 5 yrs– Maturity directly related

to quality of underlying– Important Trigger events

Bankruptcy Failure to pay Restructuring

Simple CDS contract (Source: Bionic Turtle)


Growth of CDS Market


Credit Default Swap

Types of CDS– Single-name CDS– Multi-name CDS

Settlement Methods– Physical Settlement– Cash Settlement– Fixed Amount Settlement

Uses of CDS– Hedging– Speculation

Speculation in CDS– Structured Investment

Vehicle (SIV) market– Naked CDS– Secondary market for CDS

How is CDS different from insurance?– Seller is not regulated entity– No need to own reference

entity– No need to maintain

reserves for pay-off

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CDS PricingValue of CDS (to the protection buyer) = PV [contingent leg] –

PV [fixed (premium) leg]

Where,D(ti) = Discounting Factor,q(ti) = Survival Probability,S = CDS Premium,di = Accrual days as a fraction of a year,{q(ti-1) - q(ti)} = Survival Probability till credit default event,R = Recovery Rate.

Source: CDS Primer by Nomura Fixed Income Research

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Subprime Crisis Reasons for subprime loans

– Lower interest rates– Increase in prices of houses– Home equity loans– Additional profits to FIs

Types of subprime loans– Interest Only Mortgage– Adjustable Rate Mortgage

(ARM) 2/28 ARM

– Low Initial Fixed Rate Mortgage

Predatory Borrowing/ Lending– Lack of information

(Options available) Moral Hazards

– Loan servicer/ Borrowers


The sequence of events


Securitization Process

Traching Process– Senior Tranche– Subordinate/Mezzanine

Tranche– Equity Tranche

Predatory Borrowing and Lending

Adverse Selection Moral Hazards

Source: Infosys

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Role of CDS in Subprime Crisis

Source:YieldCurve.com


CDS Statistics

Source: Infectious Greed


CDS Market OTC Market – Disadvantages

– Due diligence for counterparty creditworthiness (additional cost)– Dealer market (dealers acts as market makers)– No valuation by an independent valuation agent, etc.

Credit Derivative Indices – CDX/ iTraxx– CDX – North American & Emerging Market companies– iTraxx – Rest of the world– Benefits – tradability, liquidity, operational efficiency,

transaction cost, transparency BIS Recommendations

– Delays in documenting & confirming transactions– Expanding use of collateral– Potential use of clearing house


The Changes in CDS Market Central Counterparty Hardwiring the Auction Protocol ISDA Determination Committee

What is Central Counterparty?– buyer to every seller and the seller

to every buyer Benefits of CCPs

– Increased liquidity– Multilateral netting– Mitigating counterparty risk– Neutral, transparent valuation– Improve operational efficiency

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CDS Auction Rationale behind Auction Process

– Physical Settlement of CDS contracts– CDS outstanding greater than the volume of bonds issued– Artificial rise in the price of the bonds– Need for transparent, trustworthy price for Cash Settlement– Elimination of Basis Risk

Overview of CDS Auction Process

CDS Auction – Stage 1– 2-way market quotes– Physical settlement request– Inside Market Midpoint – Open Interest

Stage 1 Results published are –– The inside market midpoint– The size and direction of the

open interest– Any Adjustment Amounts

CDS Auction – Stage 2– matching open interest and

creating a final price

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Auction Process: Lehman Brothers

Quotation Size – $5 million

Inside Market Midpoint – 9.75

Open Interest –$4.92 billion to sell

Adjustment Amount – $12500

Final Settlement Price – 8.625

Note: Prices are expressed relative to a par value of 100

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CDS Data Sources International Swaps and

Derivatives Association– ISDA Master Agreement– Administrating Auction Process– ISDA Determination committee– Semiannual Reports

Bank for International Settlement– BIS semiannual data for single-

name, multi-name instruments– CDS by counterparty, sector and

rating British Bankers' Association

– Reports every two years on credit derivatives activities in London/ Europe

The Office of the Comptroller of the Currency– Quarterly report on bank

derivatives activities in US – OCC shared the regulatory

information on CDS after its introduction to market

The Depository Trust and Clearing Corporation – Trade Information Warehouse,

comprehensive trade database– Weekly information on credit

derivative products, transaction types, etc.

Other data sources –– Bloomberg, Markit, S&P,

Moodys, Fitch Rating, etc.

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Central Counterparty Settlement TriOptima

– Elimination of USD 30.2 trillion of CDS notional trades (in 2008)– Elimination of USD 5.5 trillion of CDS notional trades (first quarter

of 2009)


Central Counterparty Settlement

IntercontinentalExchange Trust NYSE Euronext LIFFE &

LCH.Clearnet SA CME Group Inc./ Citadel

Investment Group Eurex AG.


Comparison of CCPsParties ICE Trust/ CCorp NYSE Euronext

LIFFE/ LCHCME

Group/Citadel Eurex AG

Program Type CCP CCP E-trading & CCP CCP

Presence in US/ Europe Europe Europe/ US Europe

Started on 09/03/2009 22/12/2008 Yet to start Yet to start

Products

Currently - North American CDX

indicesProposed - American single names in 3Q09

European iTraxx indices in 2Q09

European single names in 3Q09

Currently - iTraxx Europe CDS indices in UK

Proposed - iTraxx European indices

by Dec 2009US indices by

H12010

Proposed – CDX indices, iTraxx

indices, and single name CDS

Proposed –European index and single name

CDS

Pricing by Markit Markit MarkitEurex clearing pricing team,

Markit


Comparison of CCPs

Parties ICE Trust/ CCorp

NYSE Euronext LIFFE/ LCH CME Group/Citadel Eurex AG

Features

Integration and co-

existence with other

elements of CDS

processing infrastructur

e (like DTCC)

Novation within a Eurozone legal

frameworkLCH.Clearnet

SA to act as the CCPISDA

documentation compliance

DTCC TIW as central registrar

Open architecture, enabling market participants to

execute or book CDS trades through party-to-party

negotiation, IDB brokered, CMDX Request for Quote (RFQ) platform, or other

electronic matching venuesMigration Utility to migrate

existing bilateral OTC contracts to standardized, centrally cleared contracts

Leverage of existing OTC CDS and Eurex

Clearing infrastructureNo additional technical

connectivity required for existing Clearing Members, STP

processing with the DTCC Deriv/SERV Trade Information

WarehouseDedicated clearing fund

for CDS


General Global Settlement Procedure Functional Model

– DTCC TIW for trade capturing, confirmation and settlement

– Check various criteria before novation by central counterparty

Trade Lifecycle– Flags, novation,

netting, collateral, etc.

CDS Pricing– Markit pricing info.– Eurex clearing

pricing team

Risk Management Model– Margins &

Collaterals

End of day processing– Reports with current

positions, margin summary, collateral reports

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Credit Derivatives Market in India Need for Credit Derivatives

– Eliminate uneven distribution of risk in market

– Banks & FIs highly skewed with loan portfolios with no bond portfolio

– Mutual funds, Hedge funds, Insurance companies & Pension funds mostly have bond portfolio and no loan portfolio

Expected Participants– Banks, Financial Institutions,

Insurance companies, Mutual funds

Benefits of credit derivatives– Transfer credit risk & free up

capital by banks– Retaining existing client

relationship– Construct & manage the credit

risk portfolio of own choice– Diversification of credit risk

Minimum Conditions– Direct– Explicit– Irrevocable– Unconditional


RBI Draft Guidelines Participants allowed

– Protection buyers: Commercial Banks, Primary Dealers

– Protection seller: Commercial Banks, Primary Dealers

Product Requirements– Protection buyer must have a

credit risk exposure– Settlement Methods

Physical Settlement Cash Settlement Fixed Amount Settlement

– ISDA Master Agreement compliance

Product Requirements – Credit Events

Bankruptcy Obligation Acceleration Obligation Default Failure to pay Repudiation/ Moratorium Restructuring

– Minimum Requirements Direct, Explicit, Irrevocable

& unconditional No recourse to protection

buyer for losses Specified post-credit-event

valuation period Legal enforceability

Continued…


Product Requirements– Minimum Requirements

Credit events specified at minimum are –

- Failure to pay- Bankruptcy, insolvency- Restructuring

– Seniority of underlying– Right/Ability to transfer

underlying asset/obligation– Grace period < Loan period– Protection buyer has right to

inform Protection Seller about the occurrence of credit event

Risk Management– Sound risk management policies &

procedures (due diligence)– Counterparty limits by PBs– Awareness of legal risk– Adequate oversight by Board of

Directors and senior management Procedures

– Measuring, monitoring, reviewing, reporting and managing the risks

– Analysis & minimization of risk– Management of market risk in

trading books– Management of legal risk– Management of liquidity reserve

RBI Draft Guidelines

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CDS and its settlement in India Feelers sent out to many banks to check the acceptability Possible CDS Settlement –

– OTC Market– Trade Reporting Platform – Once market matures Central Counterparty Settlement

Role of CCIL Some issues to be addressed are –

– Regulatory approvals for insurance companies & mutual funds to maximize the number of participants

– More lights on restructuring as credit event– Clear distinction between insurance contracts and CDS contracts

“There is surely a need for such a product (CDS)”- Ashish Vaidya, Head of interest rate trading, HDFC Bank.

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References BIS Quarterly Review – BIS CDS Trading and Clearing Solution – CME Group Credit Default Swap – Wikipedia A simple explanation of the subprime crisis – David Waring (InformedTrade) Derivative (finance) – Wikipedia CDS: changing the contract – HSBC Global Research Draft CDS Guidelines – RBI European OTC Clearing Solution for CDS – Eurex Clearing Options, Futures and Other Derivatives – John C. Hull Credit Default Swap (CDS) Primer – Nomura Fixed Income Research OCC's Quarterly Report on Bank Derivatives Activities – OCC Report of the Working Group on Introduction of Credit Derivatives in India –

Department of Banking Operations and Development Subprime Mortgage Crisis – Wikipedia Introduction to Credit Derivatives – Vinod Kothari

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credit default swaps in india

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