CREDIT RISK AND DERIVATIVES

CREDIT DERIVATIVES ARE THE FINANCIAL

INSTRUMENTS DESIGNED TO TRANSFER
THE CREDIT RISK OF ONE COUNTERPART
TO ANOTHER.CREDIT RISK ARISES MAIN-
LY DUE TO THE DEFAULT OF THE DEBT-
OR OR DUE TO THE DETERIORATION OF
THE CREDIT QUALITY OF THE DEBTOR.
DUE TO THE INCIDENCE OF SUCH RISK
THE CREDITOR CAN ONLY RECEIVE THE
AMOUNT THAT THE DEBTOR PROVIDES.
11 July 2013 PROF. D GOPINATH 1
 CREDIT RISK AND DERIVATIVES
IT IS RELATED TO THE OFFSETTING OF
CREDIT RISK TO BE INCURRED IN A
FIRM. THE CONCEPT OF DERIVATIVE IS
TO CREATE A CONTRACT THAT DERIVES
FROM AN ORIGINAL CONTRACT OR
ASSET.A CREDIT DERIVATIVE IS A
CONTRACT THAT INVOLVES A CONTRACT
BETWEEN PARTIES IN RELATION TO A
RETURN FROM THE CREDIT ASSET.
WITHOUT TRANSFERRING THE ASSET.
11 July 2013 PROF. D GOPINATH 2
 CREDIT DERIVATIVES
THERE ARE SUCH INSTRUMENTS WHICH
TRANSFER EITHER SPECIFIC OR ALL THE
INHERENT RISKS OF A CREDIT POSITION
FROM ONE PARTY TO THE OTHER.HERE
THE RISK SELLER TRANSFERSITS RISK
TO THE RISK BUYER AGAINST PAYMENT
OF A PREMIUM. THESE CONTRACTS ARE
PRIVATE AND CONFIDENTIAL WHICH
ALLOW THE USER TO MANAGE THEIR
EXPOSURE TO CREDIT RISK.
11 July 2013 PROF. D GOPINATH 3
 CREDIT DERIVATIVES
THEY ARE ALSO TERMED AS OFF BALANCE SHEET
FINANCIAL INSTRUMENTS WHICH PERMIT ONE
PARTY (BENEFICIARY) TO TRANSFER CREDIT
RISK OF A REFEREN-CE ASSET OWNED BY IT
TO ANOTHER PARTY(GUARANTOR) WITHOUT
ACTUAL-LY SELLING THE ASSET. A CREDIT
DERI-VATIVE IS A SPECIFIC FINANCIAL PROD-
UCT DESIGNED TO MITIGATE OR TO ASSUME
SPECIFIC FORMS OF CREDIT RISK BY HEDGERS
AND SPECULATORS.

11 July 2013 PROF. D GOPINATH 4

 CREDIT DERIVATIVES
THE CREDIT DERIVATIVES GENERALLY
HEDGE DIRECTLY TO A PARTICULAR
DEBTOR. THE CREDIT RISK IS TYPICALLY
DEBTOR SPECIFIC.HERE THE FOCUS IS
PLACED ON INDIVIDUAL SOLUTIONS
SPECIFICALLY DESIGNED TO FULFILL
CUSTOMER SPECIFIC DESIRES WITH AN
EYE ON THEIR BALANCE SHEET.THE
SOLUTIONS ARE CUSTOMER SPECIFIC
WITH NO SECONDARY MARKET.
11 July 2013 PROF. D GOPINATH 5
 CREDIT DERIVATIVES- FEATURES
1. IT IS A BILATERAL CONTRACT COMPRISING
TWO PARTIES. ONE IS THE CREDIT RISK
PROTECTION BUYER OR BENEFICIARY AND
THE OTHER IS THE CREDIT RISK
PROTECTION SELLER OR GUARANTOR.
2. THESE ARE TRADED ON OTC MARKET.OTC
PRODUCTS ARE DEALT WITH OUTSIDE THE
REGULATED EXCHANGES SO THEY PERMIT
MAXIMUM FLEXIBILITY IN DESIGNING THE
CONTRACT AS PER THE NEEDS OF PARTIES.
11 July 2013 PROF. D GOPINATH 6
 CREDIT DERIVATIVES :FEATURES
3. IN CREDIT DERIVATIVES CONTRACT THE
BENEFICIARY(PROTECTION BUYER) PAYS
A FEE CALLED PREMIUM AS IN INSURA-
NCE BUSINESS TO THE GUARANTOR
(PROTECTION SELLER) i.e A PARTY WHI-
CH WANTS TO PROTECT ITSELF FROM
THE FUTURE CREDIT RISK WILL PAY FEE
TO THE OTHER PARTY WHICH TAKES
SUCH RISK.
11 July 2013 PROF. D GOPINATH 7
 CREDIT DERIVATIVES FEATURES
4.THE REFERENCE ASSET FOR WHICH CREDIT
RISK PROTECTION IS PURCHA-SED AND SOLD
IS PREDETERMINED. EX:-A BANK LOAN,
CORPORATE BONDS, DEB-ENTURES, TRADE
RECEIVABLES ETC.
5.THE PROTECTION FROM CREDIT RISK REGARD-
ING REFERENCE ASSET IS ARISEN DUE TO
VARIOUS CAUSES WHICH ARE KNOWN AS CRE-
DIT EVENTS.EX:- BANKRUPTCY, INSOLVENCY,
PAYMENT-DEFAULT,PRICE DECLINE,RATINGS.
11 July 2013 PROF. D GOPINATH 8
 CREDIT DERIVATIVES-FEATURES
6. VARIOUS INSTRUMENTS ARE BEING USED IN
THE CREDIT-DERIVATIVES MARKET LIKE
CREDIT-DEFAULT SWAPS, TOTAL RETURN
SWAPS, CREDIT OPTION, ETC.
7.THE SETTLEMENT BETWEEN THE COUNTER-
PARTIES IN SUCH CONTRACT ON THE CREDIT
EVENT IS SETTLED ON CASH OR IN TERMS OF
PHYSICAL FINANCIAL ASSETS(LOAN/BOND). IF
THE GUARANTOR IS NOT SATISFIED WITH THE
PRICING OR VALUATION HE HAS A RIGHT TO
ASK FOR PHYSICAL SETTLEMENT.

11 July 2013 PROF. D GOPINATH 9

 CREDIT DERIVATIVES-FEATURES
8.IN GENERAL CREDIT DERIVATIVES GUIDELINES
ARE ISSUED BY INTERNATIONAL SWAPS AND
DERIVATIVES ASSOCIATION KNOWN AS
MASTER AGREEMENT AND THE LEGAL FORMAT
OF A DERIVATIVE CONTRACT.
CREDIT DERIVATIVES ARE THE MOST IMPORTA-
NT FINANCIAL INNOVATIONS WHICH ASSIST
CREDIT MANAGERS TO REALIZE THEIR CREDIT
EXPOSURES AND THEN TO ACT OPTIMALLY TO
HEDGE AND REPLICATE CREDIT RISK.
11 July 2013 PROF. D GOPINATH 10
 CREDIT RISK-CONCEPT
RISK MAY BE OF TWO TYPES:-
1. MARKET RISK. 2.FIRM SPECIFIC RISK.
MARKET RISK ARISES DUE TO MOVEMENTS
IN INTEREST RATES,EXCHANGE
RATES,STOCK PRICES, COMMODITY
PRICES, TRADE RESTRICTIONS,
ECONOMIC SANCTIONS, GOVT POLICI-
ES ETC IN ADVERSE DIRECTIONS
CREATING AN EFFECT ON THE FIRMS.

11 July 2013 PROF. D GOPINATH 11

 CREDIT RISK- CONCEPT.
FIRM SPECIFIC RISK REFERS TO THE POSS-
BILITY THAT AN INDIVIDUAL BORROW-
ERS CIRCUMSTANCES CHANGE FOR THE
WORSE RESULTING IN FAILING TO MAKE
OBLIGATGED PAYMENTS. THE MARKET
RISK IS MANAGED BY ENTERING INTO
OFFSETTING OR HEDGING TRANSACTION
BUT IN THE PERVIEW OF FIRM SPECIFIC
RISKCOMMONL CALLED AS CREDIT RISK.
11 July 2013 PROF. D GOPINATH 12
 CREDIT RISK-CONCEPT
CREDIT RISK REFERS TO THE POSSIBILITY
THAT A BORROWER WILL FAIL TO SERV-
ICE OR REPAY A DEBT ON TIME. IT IS
ALSO DEFINED AS THE POSSIBLITY OF
LOSSES ASSOCIATED WITH DIMINUTION
IN THE CREDIT QUALITY OF BORROWER
OR COUNTER PARTIES. FOR EX IN A
BANK THE PARTY MAY REFUSE OUTRIG-
HT COMMITMENTS, SETTLEMENTS ETC.
11 July 2013 PROF. D GOPINATH 13
 CREDIT RISK- FORMS
1. DIRECT LENDING:- PRINCIPAL/ INTERE-
ST MAY NOT BE REPAID.
2. IN CASE OF GUARANTEE/LETTER OF
CREDIT FUNDS MAY NOT BE COMING.
3. FUNDS SETTLEMENT MAY NOT BE EFFE-
CTED IN SECURITIES TRADING.
4. IN CASE OF CROSS BORDER EXPOSURE
FREE TRANSFER OF FUNDS MAY CEASE
OR BE RESTRICTED BY GOVERNMENTS.

11 July 2013 PROF. D GOPINATH 14

 CREDIT DERIVATIVES
INSTRUMENTS
THE BASIC FEATURE OF CREDIT DERIVAT-
IVE INSTRUMENTS IS THAT THEY
SEPARATE THE CREDIT RISK FROM THE
TOTAL RISK ALLOWING THE TRADING OF
CREDIT RISK WITH THE PURPOSE OF
REPLICATING CREDIT RISK, TRANSFERI-
NG VREDIT RISK AND HEDGING CREDIT
RISK.THE IMPORTANT INSTRUMENTS OF
CREDIT DERIVATIVES ARE:-
11 July 2013 PROF. D GOPINATH 15
 CREDIT DERIVATIVES
INSTRUMENTS
1.CREDIT DEFAULT SWAPS:- (CDS) IS A
BILATERAL DERIVATIVE CONTRACT
WHERE ONE PARTY AGREES TO PAY
ANOTHER PARTY PERIODIC FIXED PAY-
MENTS IN EXCHANGE FOR RECEIVING
“CREDIT EVENT PROTECTION” IN THE
FORM OF PAYMENT FOR ANY ADVERSE
CREDIT EVENT OVER A PRE AGREED
PERIOD.
11 July 2013 PROF. D GOPINATH 16
 CREDIT DERIVATIVES
INSTRUMENTS (CDS)
THE TYPICAL CREDIT EVENTS ARE BANK-RUPTCY,
FAILURE TO PAY, RESTRUCTUR-ING, FAILURE
TO PAY, REPUDIATION/ MORATORIUM.
FEATURES:- 1. IT IS A BILATERAL CONTRACT
BETWEEN PROTECTION BUYER AND SELLER.
2. THE PROTECTION BUYER PAYS A FEE TO THE
PROTECTION SELLER FOR RECEIVING THE
CREDIT EVENT PROTECTION. IT IS EXPRESSED
IN ANNUALISED BASIS POINTS OF A TRANSAC-
TIONS NOMINAL AMOUNT.

11 July 2013 PROF. D GOPINATH 17

 CREDIT DERIVATIVES
INSTRUMENTS
3.THE THIRD PARTY AND THE SPECIFIC
OBLIGATION IF ANY ON WHICH EVEN
PROTECTION IS CONCURRENTLY BOUG-
HT AND SOLD ARE REFERRED TO AS THE
REFERENCE ENTITY AND REFERENCE
OBLIGATION.
4.REFERENCE CREDIT IS THE CONTINGENT
AMOUNT WHICH WILL BE PAID BY THE
SELLER IN CASE ADVERSE EVENT OCCUR.

11 July 2013 PROF. D GOPINATH 18

 CREDIT DERIVATIVES
INSTRUMENTS
5. THE REFERENCE CREDIT MUST BE NOMINATED
UNDER THE DEFAULT SWAP CONTRACT.ALSO
THE REFERENCE CREDIT ASSET MUST ALSO BE
SPECIFIED IN THE DEFAULT SWAP CONTRACT.
ALSO TO BE MENTIONED IS THE ASSET VALUE.
6. THE CREDIT EVENT TRIGGERS THE
OBLIGATION OF THE PROVIDER OF DEFAULT
PROTECTION TO MAKE PAYMENT EITHER IN
CASH OR THE UNDERLYING ASSET.

11 July 2013 PROF. D GOPINATH 19

BASKET LINKED CREDIT SWAPS
IN THIS TYPE OF SWAP CONTRACT CREDIT
DEFAULT IS BASED ON A BASKET OF
UNDERLYING ASSETS WITH DIFFERENT
ISSUERS. FOR EX A US$100 MILLION
TRANSACTION MAY COMPRISE FOUR
UNDERLYING CREDIT ASSETS – A FIVE
YEAR GERMAN BOND, A FIVE YEAR
CANADIAN BOND, A FIVE YEAR FRENCH
BOND AND 5 YEAR SWISS BONDS.
11 July 2013 PROF. D GOPINATH 20
BASKET LINKED CREDIT SWAPS
HERE THE DEFAULT PROVIDER PROVIDES
PROTECTION ON ANY 4 ASSETS UP TO A
FACE VALUE OF US$100 MILLION ON A
FIRST TO DEFAULT BASIS IS PROVIDING
PROTECTION OF US$400 MILLION OF
CREDIT ASSETS. THE IMPORTANT POINT
IN THIS CONCEPT IS FIRST TO DEFAULT
OF ANY CREDIT ASSETS INCLUDED IN
THE BASKET OF CREDITS.
11 July 2013 PROF. D GOPINATH 21
 CREDIT DERIVATIVES
INSTRUMENTS
2. TOTAL RETURN SWAPS:- (TRS) THESE
ARE BILATERAL CONTRACTS DESIGNED
TO REPLICATE THE ECONOMIC RETURNS
ARISING OF UNDERLYING ASSET OR A
PORTFOLIO OF ASSETS FOR A PRE-SPEC-
IFIED TIME.HERE ONE PARTY PAYS THE
TOTAL RETURN ( INTEREST+CAPITAL
APPRECIATION) OF A ASSET AND IN
RETURN THE OTHER PAYS FLOATING
RATE PAYMENTS (LIBOR + SPREAD).
11 July 2013 PROF. D GOPINATH 22
 CREDIT DERIVATIVES
INSTRUMENTS- TRS
THESE FLOATING PAYMENTS REPRESENTS
A FUNDING COST OF THE TR PAYER. A
TRS CONTRACT ALLOWS THE TRS
RECEIVER TO OBTAIN THE ECONOMIC
RETURNS OF AN ASSET WITHOUT
FUNDING THEREON ITS BALANCE SHEET.
SO TRS IS PRIMARILY OFF BALANCE
SHEET FINANCIAL VEHICLE.

11 July 2013 PROF. D GOPINATH 23

 CREDIT DERIVATIVES-TRS
TOTAL RETURN PAYERS ARE TYPICALLY SUCH
LENDERS AND OTHER INVESTORS WHO WANT
TO REDUCE THEIR EXPOSU-RE TO AN ASSET
WITHOUT REMOVING IT FROM THEIR BALANCE
SHEET.
OTHER RETURN RECEIVERS ARE TYPICALLY SUCH
INSTITUTIONS WHO WANT TO INVEST FUNDS
ON A LEVERAGE BASIS TO DIVERSIFY THEIR
PORTFOLIOS OR INTEND TO HIGHER RETURN
BY TAKING ON RISK EXPOSURE.
11 July 2013 PROF. D GOPINATH 24
 CREDIT SPREADS
IT REPRESENTS THE MARGIN BETWEEN
THE RISK FREE RATE OF RETURN DESIG-
NATED TO COMPENSATE THE INVESTOR
FOR THE RISK UNDERTAKEN ON DEFAU-
LT OF THE UNDERLYING ASSET. IT IS
THE DIFFERENCE BETWEEN RETURN OF
THE UNDERLYING SECURITY AND THE
RETURN ON THE CORRESPONDING RISK
FREE SECURITY.
11 July 2013 PROF. D GOPINATH 25
 CREDIT SPREAD
IT IS TO UNDERSTAND THE RELATIVE
CREDIT VALUE CHANGES IN CONTRACT
TO CHANGES IN THE INTEREST RATES,
CREDIT SPREAD EXPECTATION,AND THE
TERM STRUCTURE OF CREDIT SPREAD.
THIS IS REQUIRED TO DESIGN CREDIT
OPTION DERIVATIVES WHICH WOULD BE
THE NATURAL EXTENSION OF FINANCIAL
MARKETS TO UNBUNDLED RISK.
11 July 2013 PROF. D GOPINATH 26
 CREDIT OPTIONS
IT GIVES THE OPTION HOLDER THE RIGHT
TO SELL A BOND TO THE OTHER PARTY
(INVESTOR) AT A CERTAIN STRIKE PRICE
EXPRESSED IN TERMS OF A SPREAD OV-
ER A BENCHMARK. ON THE EXPIRATION
IF THE ACTUAL SPREAD IS LOWER THAN
THE STRIKE PRICE THEN THE BOND HOL-
DER WILL NOT EXERCISE THE OPTION,
THEREBY THE OPTION IS WORTHLESS.
11 July 2013 PROF. D GOPINATH 27
 CREDIT OPTIONS
IF THE ACTUAL SPREAD IS HIGHER THAN
THE STRIKE PRICE THEN THE BOND HOL-
DER WILL DELIVER THE BOND AND THE
INVESTOR PAYS THE PRICE WHOSE
YIELD SPREAD OVER THE BENCH MARK
EQUALS THE STRIKE SPREAD.CREDIT OP-
TION MAY BE PUT AND CALL OPTIONS.
PUT OPTIONS ARE 1. PRICE OPTIONS 2.
SPREAD OPTIONS.
11 July 2013 PROF. D GOPINATH 28
 CREDIT OPTIONS
IN THE PRICE PUT OPTIONS THE OPTION
WRITER AGREES TO COMPENSATE THE
OPTION BUYER FOR A DECLINE IN VALUE
OF THE UNDERLYING ASSET BELOW THE
STRIKE PRICE. UPON THE EXERCISE OF
THE CREDIT OPTION THE PAYOFF IS
DETERMINED BY SUBSTRACTING THE
MARKET PRICE FROM THE STRIKE PRICE
OF THE ASSET.
11 July 2013 PROF. D GOPINATH 29
 CREDIT OPTIONS
STRIKE PRICE IS USUALLY DETERMINED BY
TAKING THE PRESENT VALUE OF THE
ASSET’S CASH FLOW DISCOUNTED AT
THE RISK FREE RATE PLUS THE STRIKE
CREDIT SPREAD. THE SPREAD PUT
OPTION ARE BASED UPON THE SPREAD
BETWEEN THE BOND YIELD AND THE
CORRESPONDING TREASURY YIELD.

11 July 2013 PROF. D GOPINATH 30

 CREDIT OPTIONS
SECOND TYPE OF CREDIT OPTIONS ARE
REFERRED TO AS CALL OPTIONS WHICH
ARE BASED ON THE CREDIT SPREAD.
THESE ARE STRUCTURED IN SUCH A WAY
THAT THE OPTION IS IN THE MONEY
WHEN THE CREDIT SPREAD EXCEEDS
THE SPECIFIED (STRIKE) SPREAD LEVEL.

11 July 2013 PROF. D GOPINATH 31

 CREDIT LINKED NOTES
THIS INSTRUMENT ENABLES THE INVEST-
OR TO PURCHASE AN ASSET WITH A
RETURN LINKED TO THE CREDIT RISK OF
THE ASSET ITSELF AND THE ADDITIONAL
CREDIT RISK TRANSFERRED BY WAY OF
CREDIT DERIVATIVE BETWEEN THE
PARTIES.IT IS A COMBINATION OF A
REGULAR NOTE (BOND) AND A CREDIT
OPTION.
11 July 2013 PROF. D GOPINATH 32
 CREDIT LINKED NOTES
BEING A REGULAR NOTE WITH COUPON,
MATURITY AND REDEMPTION IT IS AN
ON BALANCE SHEET INSTRUMENT JUST
LIKE CREDIT DEFAULT SWAP.THE PRICE
OR COUPON OF THE NOTE IS BASED ON
THE PERFORMANCE OF A REFERENCE
ASSET. IT MEANS THE INVESTOR RECEI-
VES A COUPON AND REDEMPTION AT
PAR VALUE UNLESS THERE HAS BEEN
CREDIT EVENT BY A REFERENCE CREDIT.
11 July 2013 PROF. D GOPINATH 33
 CREDIT LINKED NOTES
IF THERE IS A CREDIT EVENT IN THAT
CASE THE AMOUNT WILL BE REDEEMED
AT PARVALUE MINUS A CONTINGENT
PAYMENT TO THE INVESTOR.THE ISSUER
RECEIVES A PREMIUM FOR TAKING
EXPOSURE TO THE REFERENCE CREDIT.
THE PREMIUM FORMS PART OF THE
COUPON THAT IS PAID TO THE
INVESTOR.
11 July 2013 PROF. D GOPINATH 34
 MECHANISM OF CREDIT LINKED
NOTES
CLN’S ARE CREATED THROUGH A TRUST
OR SPECIAL PURPOSE VEHICLE (SPV)
WHICH IS COLLATERALIZED WITH AAA
RATED SECURITIES. IT IS A CREDIT SW-
AP BETWEEN A BANK AND THE ISSUER.
IT CAN ALSO BE ISSUED BY A NBFC OR A
BANK DIRECTLY.IF THE ISSUER IS A
TRUST IT ENTERS INTO A DEFAULT
SWAP WITH A DEAL ARRANGER (3RD
PARTY) IN RETURN FOR A PREMIUM.
11 July 2013 PROF. D GOPINATH 35
 CLN- MECHANISM
IN CASE OF A DEFAULT THE TRUST PAYS
THE DEALER PAR AMOUNT THE RECOV-
ERY RATE IN EXCHANGE FOR AN ANNUAL
FEE.THIS ANNUAL FEE IS PASSED ON TO
THE INVESTORS IN THE FORM OF HIGH-
ER COUPON ON THE NOTES. THE INVES-
TORS PURCHASE THE SECURITIES FROM
THE ISSUER WHICH PAYS A FLOATING
OR FIXED COUPON DURING THE LIFE.
11 July 2013 PROF. D GOPINATH 36
 CLN - MECHANISM
COUPON REFLECTS RISK OF ISSUER AND THE
CREDIT SWAP.AT THE TIME OF MATURITY THE
INVESTORS RECEIVE THE PAR AMOUNT IF NO
CREDIT EVENT OCC-URS (REFERENCED CREDIT
DEFAULTS) OR DECLARES BANKRUPTCY. IF
THE CRE-DIT EVENT OCCURS THE PRINCIPAL
AT PAR MINUS CONTINGENT PAYMENT WILL
BE PAID TO INVESTORS. THE INVESTOR IS
SELLING THE CREDIT PROTECTION IN
EXCHANGE FOR HIGHER YIELD IN TERMS OF
COUPON ON THE NOTE.

11 July 2013 PROF. D GOPINATH 37