CREDIT DERIVATIVES - BASIC CONCEPTS

Golaka C Nath.*
Introduction: Credit Derivatives are contracts that help an investor with a given type of risk appetite to transfer a loan's / bond's inherent credit risk to another investor with a different risk appetite while keeping the ownership of the underlying loan/bond. It is a protection against the failure of the borrower of the loan or issuer of the bond to honor its commitment on the expected dates of recovery/payments. Global credit derivatives market has grown significantly over last one decade or so but the growth was halted due to the unfolding of the financial crisis. According to estimates, the gross notional amount of outstanding credit derivative instruments increased from US$2 trillion at the end of 2002 to more than US$30 trillion by the end of 2009, after reaching a peak of US$58 trillion in 2007. A significant part of the market is concentrated on credit instruments related bonds and loans of US corporations and mortgages - a sizable portion of the market currently traded is derived from debt instruments issued by sovereign debtors. According to DTCC as of May 26, 2011, the current value of outstanding credit derivatives on Greece sovereign debt is $78bn and the same on Italy's sovereign debt totals $284bn. Globally, commercial banks play a very dominant role in the credit derivatives market. These banks use these instruments to diversify their risky investment assets. These products can also be used to decrease credit-risk exposure in circumstances where banks may think that the regulatory capital charges prescribed on the exposure to be disproportionately large. Hence credit derivatives are also used as a tool for regulatory arbitrage by changing the credit risk profile in an investment or exposure. There are two types of credit risk 'default' and 'degradation'. Default risk arises when the borrower of a loan or the issuer of a bond fails to service the loan/bond on due dates of payment of principal and interest/coupon. Degradation is the fall in credit quality of an exposure due to a credit event. Since the instruments are generally credit rated by leading credit rating agencies, a fall in rating is the degradation of credit. These two risks are different and hence priced differently. Degradation of credit quality may not mean a default as the borrower of the loan or the issue of the bond will pay off at maturity. However, after degradation, the possibility of default increases and hence the intrinsic value of the loan/bond decreases. A default mean loss of value of the loan or bond excluding the recovery rate arrived out of quality of collaterals held against the bond or loan. Credit derivatives are designed to transfer the risk from someone who cannot take the risk to someone who has higher risk appetite. By paying a premium, bond holders or loan givers purchase protection against default of the exposure. These derivatives can be constructed in the form of forwards, swaps, and options. The product allows an investor to reduce or eliminate credit risk or assume credit risk at appropriate price. These contracts can be used as hedging tools, yield enhancement, cost reduction, arbitrage, etc.

*Dr. Golaka C. Nath is a Senior Vice President, Research & Surveillance, Membership, HRD

The Clearing Corporation of India Limited

The main objective of these products is to enable the efficient transfer and repackaging of credit exposure. The definition of credit risk may encompass all credit related triggers starting from a spread widening, through a ratings downgrade, all the way to default. Commercial Banks use these products to hedge credit risk, reduce risk concentrations on their balance sheets, and free up regulatory capital in the process. New Capital Regulation as per Basel II has put an onus on commercial banks to look at these products as it helps to reduce capital in the banks' books. Banks are major protection buyers and sellers in the market. Credit derivative markets provide market participants important information about the credit risk pricing and implied risk free rate. Intuitively, a well-functioning credit derivative market provides us a reference risk free rate. If an AAA note is trading at 8.50% p.a. and an investor holding the same can buy a protection at spread of 100bps to cover the default risk of the note, effective, the risk free rate is 7.50% p.a. As Gilts in many markets display coloured rates due to many regulatory and liquidity factors, a true risk free rate can be estimated from the credit derivative market. Many markets use LIBOR swap curve to as the riskneutral default-free interest rate. History of Credit Derivatives: Credit derivatives are the outcome of several credit crises in the financial markets. The Latin American debt crisis of 1980s brought about Brady plan (US Treasury Secretary Nicholas F Brady) that attempted to offer credit enhancement to banks in exchange of their agreement to accept lower claims against the countries which agreed to introduce reforms and get funding from IMF and World Bank. The credit enhancement was done by first converting the loan exposure of global banks to

Latin American countries into bonds with agreed reduced amount and then collateralizing the notional amount with US Treasury zero-bonds which were purchased with IMF and World Bank funds. The credit derivatives market in emerging countries received momentum in 1997, contemporaneously with the Asian Crisis. However, there was no standardized agreement to deal with the disputes. International Swaps and Derivatives Association (ISDA) first published the standardized document of credit derivatives in 1999 and the same has reduced the causes of legal disputes. The recent European sovereign debt crisis has brought further thrust to this product. The credit derivatives market has seen the arrival of electronic trading platforms such as CreditTrade (www.credittrade.com) and CreditEx (www.creditex.com). Both have proved successful and have had a significant impact in improving price discovery and liquidity in the single-name default swap market. In recent months, the European Union is investigating some leading international banks (among 16 of the world's leading investment banks) over suspicions they colluded and abused their positions in providing the financial derivatives many blame for exacerbating the Eurozone sovereign debt crisis. The inquiry into credit default swaps (CDS), the controversial financial contracts designed to allow investors to insure against debt default, follows accusations that banks, many of them rescued by their host governments from collapse, played a part in forcing Greece and Ireland to seek EU bailout funds (The Guardian - 29 April 2011). More recently, swaps have emerged as one of the most powerful and mysterious forces in the crisis shaking Greece and other members of the euro zone. And they have become the subject of antitrust

investigations in both the United States and the European Union. The financial regulatory reform bill passed in 2010 called for the creation of new clearinghouses for derivatives, a class of financial transaction that includes credit default swaps. The investigations focus on whether the handful of big banks that dominate the swaps field have harmed rival organizations that could compete in markets for providing information and clearing swaps deals (The NY Times - Sep 30, 2011). It further reports that "Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small. As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized." The role of banks like Goldman also became the focus of criticism as Greece, Spain and other southern European countries found themselves facing a debt crisis. Over the last decade, Goldman and others helped the Greek government legally mask its debts so the

nation appeared to comply with budget rules governing its membership in the euro, Europe's common currency. In that role, Goldman advised Greece and, in return, collected hundreds of millions of dollars in fees from Athens. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded - or swapped - from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends - the insured and the insurer. (Time - March 17, 2008). In India credit derivatives have been allowed to be traded from Oct'11 after a long wait. However, CDS on Indian companies that have raised funds from overseas markets through issuance of Eurobonds are traded on international markets. Credit Derivatives Structure: The most common credit derivative is a single name default swap. In a credit default swap (CDS), one counterparty (known as the 'protection seller') agrees to make good another counterparty ('the protection buyer') if a particular borrowing entity (company or sovereign) ('the reference entity') experiences one of the number of defined events ('credit events') that indicate it is unable or may be

Figure 1: Single name Credit Default Swap: Example of a 5 -year 100 million Company ABC Ltd. Priced at 200bps per annum 1 Premium Protection Buyer --------------------->> 200bps p.a. for 5 years 2 If credit event happens <-------100 million-----Protection Buyer Protection Seller

<<--------------------->> --100 million ABC debt-->

Protection Seller

unable to service its debts (see Figure 1). The protection seller is paid a fee or premium, typically expressed as an annualized percentage of the notional value of the transaction in basis points and paid quarterly over the life of the transaction. Both guarantees and credit insurance in a credit derivative are designed to compensate a protection buyer for its losses if a credit event occurs. The contract depends on both the state of the world (has a credit event occurred or not?) and the outcome for the buyer (has it suffered losses or not?). A CDS is not only 'state-dependent' but 'outcomeindependent'. Cash-flows are triggered by predefined credit events regardless of the exposures or actions of the protection buyer. For this reason, credit derivatives can be traded on standardized terms amongst any counterparties. The commoditization of credit risk the most important outcome of credit derivative products. The single name CDS market allows a protection buyer to strip out the credit risk from an exposures to a company or country - loans, bonds, trade credit, counterparty exposures etc - and transfer it using a single, standardized commodity instrument. Equally, market participants can buy or sell positions for reasons of speculation, arbitrage or hedging - even if they have no direct exposure to the reference entity. For example, it is straightforward to go 'short' of credit risk by buying protection using CDS. Standardization, in turn, facilitates hedging and allows intermediaries to make markets by buying and selling protection, running a 'matched' book. A Collateralized Debt Obligation (CDO) is a credit derivative is based on a pool of risky assets. It is created as a fixed income asset. The coupon and principal payments of these assets are linked to the actual performance of the underlying pool. These

assets are divided into tranches like senior, mezzanine and subordinated/equity. As the name suggests, seniors have the highest right to receive repayments followed by mezzanine and equity. It is important to note that a CDO only redistributes the total risk associated with the underlying pool of assets to the priority ordered tranches. It neither reduces nor increases the total risk associated with the pool. The CDOs entered the emerging market in 1999. They combine securization and credit derivative technology to tranche a pool of underlying default/swaps into different classes of credit risk. The issuer of CDO notes purchases protection on the reference pool either through a default swap or by selling credit linked notes. The different tranches carry rating ranging from tripleA to single-B. An equity tranche is unrated and represents the first loss in exchange for the highest return. A default swap, made with an external counterparty, represents the super senior tranche and covers a certain percentage of the reference portfolio. The proceeds of the notes are invested in a pool of highly rated government securities. Principal and interest is paid to the highest rated notes first, while any losses are borne by the more junior tranches. Credit Risk Framework: The most striking aspect of credit derivative is its commoditization. The transfer of credit risk at a suitable price has been one of the major achievements. Credit derivative is akin to insurance where the insurance writer promises to pay in case of an agreed eventuality during the life of the contract. However, to provide this insurance, we need modalities for valuing credit risk. It is clear that the compensation that an investor receives for assuming a credit risk and the premium that a hedger would need to pay to remove a credit risk must be linked to the size of the credit risk. This can

be defined in terms of: 1) The likelihood of default or probability of default. 2) The size of the payoff or loss following default. The probability of default of a risky bond over its life can be explained with the help of term structure. We need to know the spot rates or zero rates applicable to sovereign and credit products to figure out the probability of default. Table-1 gives the basis of estimating probability of default in a very simplistic way. We have taken the term structure of 3 years for sovereign and AAA credit curve. Table-1:

default is estimated as (1 - Probability of survival). These probabilities of default pertain to a particular year. For example, the bond has a chance of defaulting to the extent of 0.69% in second year. The cumulative probability of default is estimated using the following equation: Cumulative Prob of Default = 1- (Prob of Surv in Y1* Prob of Surv in Y2) (2) The conditional probability of default or marginal probability of default of this bond for various years (conditional upon that the bond has not defaulted in any of the previous years) is simply estimated as the difference between cumulative probabilities of defaults in consecutive years. Spread for credit
Years

Parameters estimated Sovereign Curve AAA spread Credit Curve implied Forwards Sovereign Curve Credit Curve Probability of Survival Probability of Default Cumulative Probability of Default Conditional Probability of Default

1 7.60% 0.45% 8.05% 7.60% 8.05% 99.58% 0.42%

2 7.80% 0.60% 8.40% 8.00% 8.75% 99.31% 0.69% 1.10% 0.69%

3 8.00% 0.70% 8.70% 8.40% 9.30% 99.18% 0.82% 1.92% 0.82%

The first thing we need to know is that we need the sport rates or zero coupon rates for various terms. Once we have them, then we can estimate the implied forwards for both sovereign and credit. In the above example, we have estimated 1X1 forwards every year going forward. Then we estimate the probability of survival by using equation:

In the above equation, i is the sovereign spot rate and k is the credit spot rate. The probability of

quality plays a very important role in pricing the default risk. The probability of default we estimated here is the risk neutral probability of default. Empirical probability of default may vary as it depends on many other factors like business cycle, liquidity, policy for easy credit, etc. When the gap between the sovereign and credit curves widen due to many economic reasons, the cumulative probabilities of default magnifies. Table - 2 gives an example of the impact of widening spread on cumulative probability of default.

AAA Bond Years Sovereign Yield AAA Spread 1 AAA Yield 1 AAA Spread 2 AAA Yield 2 0.5 7.22 35 7.57 67 8.24 1 7.56 40 7.96 89 8.85 1.5 7.87 46 8.33 98 9.31 2 8.06 53 8.59 110 9.69 2.5 8.16 58 8.74 128 10.02 3 8.2 64 8.84 137 10.21 3.5 8.25 68 8.93 148 10.41 4 8.29 74 9.03 165 10.68 4.5 8.34 79 9.13 178 10.91 5 8.39 84 9.23 186 11.09 5.5 8.44 91 9.35 195 11.3 6 8.5 98 9.48 200 11.48

Another way of explaining the credit spread charged on credit quality is using a binomial tree. We will use one-year zero coupon corporate bond. Let us assume that the probability of default for this bond is p and the recovery rate for this bond in case of default is R% of the Face value. Let us assume that this recovery is realized at end of year 1. We can now use a simple single-period binomial tree, where the price of our risky bond, Pc is the expected payoff at year 1 discounted by the risk-free rate for the comparable year. This will give:

and the probability of default is 0.42%. The value of the bond with a possibility of default works out to be
Pc= (0.42%*100*40%)+(1-0.42%)*100) = 92.7046 (1+7.60%)

The one year sovereign bond will be priced at 92.9368 at a spot rate of 7.6%. Hence the spread for the credit quality, s, can be defined in the following manner:

Pc= (p*100*R)+(1-p)*100 (3) (1+i)

For our example, we will assume the recovery rate is the recovery rate for a senior subordinate at 40%

Pc=

100 (1+i) (1+s)

(4)

For this the bond, the fair credit spread is 25bps with an assumption of 40% recovery rate. If the recovery rate changes, the spread will also undergo change.

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One can also fairly approximate the credit spread using the credit triangle formula which states that the annualized compensation for assuming a credit risk is equal to the annual probability of default multiplied by the loss in case of a default (1recovery rate). That means our fair spread will be 0.42%*60% =0.25% for this bond. We can solve for any spread, s, provided we know the recovery rate, R, and probability of default, PD. The term (1-R) is commonly used as Loss Given Default (LGD). The above is a simple but very powerful tool for the traders to look at credit spreads and what they imply about default probabilities and recovery rates, and vice-versa. Within the credit derivatives market, understanding such a relationship is essential when thinking about how to price instruments.

spread the subordinate will pay over the senior.

In our case, if the recovery rate for subordinate is only 25%, and the senior spread is 0.25%, then the spread for subordinate will be 0.31%. Probability of Default and Transition Matrix Credit Transition Matrices are very important and powerful tools provided by Rating Agencies for estimating probability of default from the empirical angle. A transition matrix is nothing but the possibility of various rating movements of a bond during one year. The Table-3 gives an example of a typical transition matrix.

Table 3: -One Year Ratings Transition Matrix

Original Rating AAA AA A BBB BB B CCC Default Probability of migrating to rating by year end (%) AAA 93.66 0.66 0.07 0.03 0.03 0 0.16 0 AA 5.83 91.72 2.25 0.25 0.07 0.1 0 0 A 0.4 6.94 91.76 4.83 0.44 0.33 0.31 0 BBB 0.08 0.49 5.19 89.26 6.67 0.46 0.93 0 BB 0.03 0.06 0.49 4.44 83.31 5.77 2 0 B 0 0.09 0.2 0.81 7.47 84.19 10.74 0 CCC 0 0.02 0.01 0.16 1.05 3.87 63.96 0 Default 0 0.01 0.04 0.22 0.98 5.3 21.94 100

Further, when an entity defaults, all its bonds will default together and hence all bonds issued by the entity will have the same credit risk and probability of default, save only the class of bonds having different claims on the company's balance sheet. A senior bond will have higher priority over a subordinate bond in terms of liquidation recovery. So using a simple formula we can estimate the

This tells an investor that a BBB rated paper at the beginning of the year is likely to maintain its own rating class to an extent of 89.26% while it is expected to be downgraded to BB to an extent of 4.44% and it may move to default category to an extent of 0.22%. Using this matrix, we can fairly price the BBB bond given the general credit spreads factored by the market. We will explain with the use

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of a 5-year BBB 8.56% semi-annual coupon bond currently trading at 10.12%. As per the transition matrix, the intrinsic value or fair price of the bond will be as per Table - 4:

Pricing and Structuring Credit Default Swap

Pricing of a CDS is best explained with the use of Merton framework in Black-Scholes pricing formula for options. Structural models BBB Corporate Curve Estimated Price Probability * Price derive the PD by analyzing the capital AAA 0.03 9.00% 98.26 0.03 structure of the firm - value of the assets of AA 0.25 9.24% 97.33 0.24 the firm vis--vis value of the debt. Since A 4.83 9.52% 96.25 4.65 equity holders are residual recipients, any BBB 89.26 10.12% 93.99 83.90 value after the payment of debt is left to the BB 4.44 10.78% 91.59 4.07 equity holders. Hence it is an option B 0.81 11.24% 89.96 0.73 framework. Bankruptcy will occur when CCC 0.16 18.56% 68.30 0.11 the value of the debt will be more than the Default 0.22 27.35% 40.00 0.09 value of the assets in the firm. Merton Intrinsic Value 93.81 combined the simple equation, share holders' equity value = assets value - debt For the default category, we have used the recovery value, with the original Black-Scholes equation for rate which is 40%. This price of 93.81 works out to valuing a call. 10.17% while the market is trading at 10.12% (assuming good liquidity and fair demand for this where bond). The market is paying a spread of 0.05% more for this bond and hence an indication that the recovery rate is presumed to be more or little less possibility of default. and Transition matrices also give the probability of Suppose we have a company with assets worth of default. The last column of the matrix is the 500million and a single issue of a zero coupon debt probability of default in one year. If we want to find due in 7 years with a face value of 350million. The out the probability of default for more than 1 year asset volatility is 35% and risk free rate is 7.5%. We using the same matrix, it is simply a matrix need to find the annual cost in basis points of a multiplication and little bit of adjustment using credit default swap with quarterly payments. Using Grubber and (Last column / (1-PD of first the Merton framework discussed earlier, we can year)) as given in Table-5.
Second Year PD 87.76% 0.62% 0.13% 0.06% 0.06% 0.01% 0.25% 0.00% 5.46% 0.04% 0.00% 0.00% 0.00% 0.00% 0.01% 0.00% 1.15% 6.40% 84.45% 8.77% 1.12% 0.64% 0.57% 0.00% 0.20% 0.80% 9.43% 80.23% 11.58% 1.24% 1.62% 0.00% 0.06% 0.11% 1.10% 7.74% 70.16% 9.76% 3.61% 0.00% 0.01% 0.10% 0.43% 1.76% 12.68% 71.73% 16.07% 0.00% 0.00% 0.02% 0.04% 0.32% 1.85% 5.79% 41.35% 0.00% 0.00% 0.02% 0.11% 0.54% 2.44% 10.67% 36.56% 100.00% 0.00% 0.02% 0.11% 0.54% 2.46% 11.27% 46.84%

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find out value of d1 = 1.415125924 and d2 = 0.489112965. Using these values for d1 and d2, we can figure out N(d1) as 0.921484211 and N(d2) as 0.687619138. So the value of the equity is estimated as 318,374,429 and the present value of the debt becomes the residual at 181,625,571. If the present outstanding debt had been a sovereign one, the present value would have been 207044378. Hence the difference is the present value of the CDS at 25,418,806. If the payment is amortized over 10 year period paid every quarter, then quarterly payment become 1,177,880. The spread works out 0.34% per quarter and 1.3462% per year or about 135bps. With this spread, the intrinsic value of the debt becomes 188,425,508 against the market value of 181,625,571. If the market value of the debt is 181,625,571, then it is trading the yield of 9.8244%. If we deduct the CDS spread of 1.3462%, the implied risk free rate becomes 8.4782% instead of 7.50%. If we want convert this into another structured product through an issuance of a bond with a semiannual coupon of 8% and yield of 8.35% for 7 years, the present value of the CDS is converted into this bond by issuing a face value of 45,065,440 (rounded off to 45,000,000). There are many possibilities of structuring this deal and making it more challenging by removing many simplistic assumptions like zero coupon debt. So the protection writer will receive a coupon at 8% p.a. (semi-annually) over next 7 years and finally the face value of 45million at the expiry of 7 years. The bond issued for this deal can be rated. Since the protection write is holding a bond for writing the credit default swap, he can sell the bond and transfer the risk to someone who wants to take it. Standardized credit derivative products are being traded on exchanges making it more liquid and attractive for investors. The premium for a CDS is

known as a CDS spread, and is quoted as an annual percentage in basis points of the notional amount. Protection buyers pay the spread on a quarterly basis. CDS have standard payment dates, namely, March 20, June 20, September 20, and December 20; these standard payment dates also serve as standard maturity dates. CDS transacted prior to a standard payment date are subject to a stub period up to the first standard payment date and follow the standard schedule afterwards. A CDS with a five-year maturity agreed on Oct 1, 2011, for example, would become effective on Oct 2 with accrued premium due on Dec 20; subsequent payments would occur on regular dates after until maturity on Dec 20, 2016. If the spread for a distressed credit is sufficiently high, the CDS will trade up-front, that is, the buyer will pay the present value of the excess of the premium over 500 (100/500 are standard coupons on CDS) basis points at the beginning of the trade, and pay 500 basis points per annum for the life of the swap. Regulatory Issues and Challenges There are many benefits in credit derivatives for users. If used inappropriately, the products can bring downfall of an organization as selling protection without proper pricing mechanism can be dangerous. The usage of credit derivatives has potentiality for distorting existing risk-monitoring and risk-management incentives for banks. This can increase in banks' risk profiles by writing protection as fees are received upfront to bolster the bank books. Banks use regulatory arbitrage to their advantage and hence they may off-load low-risk assets and replace them with higher-risk assets and buy credit protection. The bank's incentive to perform efficient monitoring function over its loan portfolio may be significantly compromised if the bank subsequently purchases credit protection on the

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exposure using credit derivative. Whereas loan sales and securitizations are structured so that monitoring incentives are retained by the originator, credit derivatives typically are not. Banking supervisors have been supportive of the credit derivatives market within the confines of their interpretations of the BIS regulatory capital framework. Broadly speaking, the regulatory treatment of credit derivatives depends on whether the position is uncovered or hedges an existing position. The regulatory capital charge on an uncovered position is generally the same as the charge on an equivalent cash position in the reference asset. Use of Credit derivatives Banks can diversify their loan portfolios in a more cost effective manner with the use of credit derivatives. Banks use funding arbitrage and product restructuring as a motivation for writing credit risk. The commoditization of credit risk in an efficient manner is the most important benefit of the credit derivative market. Banks can reduce concentration on credit portfolios by using credit derivatives. Credit derivatives may be used for regulatory arbitrage so far as capital requirement under Basel guidelines is concerned. Capital benefit has been provided through credit derivatives. If an issuer of the bond is BBB rated entity while the protection seller is a AAA entity, the capital requirement may be less if no protection is bought for this loan. Most bank loans require a capital of 8% of Risk Weighted Asset value but large banks using internal credit risk models may provide capital on the basis of borrowers' creditworthiness. These banks will have an incentive to off-load credit-risk exposure on the loans for which the internally generated capital charge is lower than the 8 per cent regulatory requirement to ensure that the bank's return on

capital is not diluted. Credit derivatives allow managers for creating innovative product-structuring. For example, suppose that an investor wants to buy a 10-year bond issued by the Government of India and denominated in Euros. But Government of India has no such bond issued. So the investor can buy a 10-year bond issued by the Italy and denominated in euros. At the same time, the investor can sell 10year default protection on the Government of India. This investment will produce coupon payments on the Italy bonds and a regular fee for the default protection seller. In exchange for this regular fee, the investor will be exposed to the loss if India defaults on its debt. The profile of net risk and return for these transactions is very similar to a 10-year, euro-denominated bond issued by India. Credit derivatives enhance the liquidity and efficiency of markets for risky products by facilitating risk transfer and unbundling. European Debt Crisis and Credit Derivatives European Sovereign debt crisis of recent times has brought credit derivative market to the fore front once again. The CDS spreads have been increasing for European countries like Greece, Portugal, Italy, etc. Greece has a total debt of $485billion with major exposure to France (56.7%), Germany (33.9%), UK (14.6%), etc. With a possible default in sight, IMF-EU approved a 3-year $146billion bail out in May'10 releasing funds in tranches. The second bail out of $157billion was approved by EU in July'11. Greece has a 98 percent chance of defaulting on its debt in the next five years as the Government failed to reassure investors that the country can survive the euro-region crisis. It costs a record $5.8 million upfront and $100,000 annually to insure $10 million of Greece's debt for five years using credit-default swaps, up from $5.5 million in

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advance on Sept. 9, according to CMA. Greek bonds plunged, sending the 10- year yield to 25 percent for the first time (Bloomberg, Sep 13, 2011). The default probability for Greece is based on a standard pricing model that assumes investors would recover 40 percent of the bonds' face value if the nation fails to meet its obligations. Without the next tranche of aid from the troika (IMF, EU and ECB) - 8 billion euros - Greece could immediately default.

Indian scenario RBI has issued circular to initiate credit derivatives market in India with effect from Oct 2011. CDS for Indian Markets - Product Design Eligible Participants Users: - Entities are permitted to enter in CDS market by buying protection only to hedge underlying risk on corporate bonds which the

Probability of Default
25 20

Axis Title

15 10 5 0

6000 5000 4000 3000 2000 1000 0

23 -Se p 20 -1 0 -O ct 16 - 1 0 -N ov 13 -10 -D ec -1 7- J 0 an -1 3-F 1 eb -1 2-M 1 ar 2 9 - 11 -M ar 25 - 11 -A pr 20 -11 -M ay 16 11 -Ju n1 13 1 -Ju l9- A 11 ug -1 5-S 1 ep -11
Portugal Greece Italy

p-1 0 20 -O ct10 16 -N ov -10 13 -D ec10 7- J an - 11 3- F eb - 11 2-M a r11 29 -M ar25 11 -A pr -11 20 -M ay -11 16 -Ju n- 1 13 1 -Ju l-1 9-A 1 ug -1 1 5- S ep -11
Portugal Greece Italy

23 - Se

CDS of Greece, Italy and Portugul

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entities must own. No selling of protection or shorting is allowed. Exiting the bought position is allowed only by unwinding the trade with original counterparty or buy finding other buyer who otherwise satisfies other relevant conditions. Market - makers: - Entities permitted to quote both buy and/or sell CDS spreads. They would be permitted to buy protection without having the underlying bond. Commercial Banks, stand-alone Primary Dealers (PDs), NonBanking Financial Companies (NBFCs) having sound financials and good track record in providing credit facilities and any other institution specifically permitted by the Reserve Bank are allowed to work as marketmakers. Insurance companies and Mutual Funds would be permitted as market-makers subject to their having strong financials and risk management capabilities as prescribed by their respective regulators (IRDA and SEBI) and as and when permitted by the respective regulatory authorities. Eligibility norms for market-makers Commercial banks who intend to act as marketmakers shall fulfill the following criteria: o o Minimum CRAR of 11 per cent with core CRAR (Tier I) of at least 7 per cent; Net NPAs of less than 3 per cent.

o o

Net NPAs of less than 3 per cent; and Have robust risk management systems in place to deal with various risks.

PDs intending to act as market-makers shall fulfil the following criteria: o o o Minimum Net Owned Funds of `500 crore; Minimum CRAR of 15 per cent; and Have robust risk management systems in place to deal with various risks.

In case a market-maker fails to meet one or more of the eligibility criteria subsequent to commencing the CDS transactions, it would not be eligible to sell new protection. As regards existing contracts, such protection sellers would meet all their obligations as per the contract. Reference entity The reference entity in a CDS contract, against whose default the protection is bought and sold, shall be a single legal resident entity [the term resident will be as defined in Section 2(v) of Foreign Exchange Management Act, 1999] and the direct obligor for the reference asset/obligation and the deliverable asset/obligation. Reference obligation (eligible underlying for CDS) - eligibility criteria CDS will be allowed only on listed corporate bonds as reference obligations. However, CDS can also be written on unlisted but rated bonds of infrastructure companies. Besides, unlisted/unrated bonds issued by the SPVs set up by infrastructure companies are also eligible as reference obligation. In the case of banks, the net credit exposure on account of such CDS should be within the limit

NBFCs having sound financial strength, good track record and involved in providing credit facilities may be allowed to act as marketmakers, subject to complying with the following criteria: o o Minimum Net Owned Funds of `500 crore; Minimum CRAR of 15 per cent;

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of 10% of investment portfolio prescribed for unlisted/unrated bonds as per extant guidelines issued by RBI. For this purpose, an Infrastructure Company would be one which is engaged in the list of items included in the infrastructure sector as defined in the DBOD circular RBI/2010-11/68 DBOD No.Dir.BC.14/13.03.00/ 2010-11 dated July 1, 2010 and updated from time to time. Protection sellers should ensure not to sell protection on reference entities/obligations on which there are regulatory restrictions on assuming exposures in the cash market such as, the restriction against banks holding unrated bonds, single/group exposure limits and any other restriction imposed by the regulators from time to time. Requirement of the underlying in CDS The users cannot buy CDS for amounts higher than the face value of corporate bonds held by them and for periods longer than the tenor of corporate bonds held by them. To maintain naked CDS protection i.e. CDS purchase position without having an eligible underlying is not allowed. Proper caveat may be included in the agreement that the market-maker, while entering into and unwinding the CDS contract, needs to ensure that the user has exposure in the underlying. Further, the users are required to submit an auditor's certificate or custodian's certificate to the protection sellers or novating users, of having the underlying bond while entering into/unwinding the CDS contract. Exiting CDS transactions by users Users cannot exit their bought positions by entering into an offsetting sale contract. They

can exit their bought position by either unwinding the contract with the original counterparty or, in the event of sale of the underlying bond, by assigning (novating) the CDS protection, to the purchaser of the underlying bond (the transferee) subject to consent of the original protection seller (the remaining party). In case of sale of the underlying, every effort should be made to unwind the CDS position immediately on sale of the underlying. The users would be given a maximum grace period of ten business days from the date of sale of the underlying bond to unwind the CDS position. CDS transactions between related parties CDS transactions are not permitted to be entered into either between related parties or where the reference entity is a related party to either of the contracting parties. Related parties for the purpose of these guidelines will be as defined in 'Accounting Standard 18 Related Party Disclosures'. In the case of foreign banks operating in India, the term 'related parties' shall include an entity which is a related party of the foreign bank, its parent, or group entity. Other Requirements The single-name CDS on corporate bonds should also satisfy the following requirements: The user (except FIIs) and market-maker shall be resident entities; The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined a priori in the documentation; The reference asset/obligation and the deliverable asset/obligation shall be to a

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resident and denominated in Indian Rupees; The CDS contract shall be denominated and settled 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 obligations; CDS 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 year; The CDS contract must represent a direct claim on the protection seller; The CDS contract must be irrevocable; there must be no clause in the contract that would allow the protection seller to unilaterally cancel the contract. However, if protection buyer defaults under the terms of contract, protection seller can cancel/revoke the contract; The CDS contract should not have any clause that may prevent the protection seller from making the credit event payment in a timely manner, after occurrence of the credit event and completion of necessary formalities in terms of the contract; The protection seller shall have no recourse to the protection buyer for credit-event losses; dealing in any structured financial product with CDS as one of the components shall not be permitted; and dealing in any derivative product where the CDS itself is an underlying shall not be permissible.

Documentation Fixed Income Money Market and Derivatives Association of India (FIMMDA) shall devise a Master Agreement for Indian CDS. There would be two sets of documentation: one set covering transactions between user and market-maker and the other set covering transactions between two market-makers. Standardization of the CDS Contract The CDS contracts shall be standardized. The standardization of CDS contracts shall be achieved in terms of coupon, coupon payment dates, etc. as put in place by FIMMDA in consultation with the market participants. Credit Events The credit events specified in the CDS contract may cover: Bankruptcy, Failure to pay, Repudiation/moratorium, Obligation acceleration, Obligation default, Restructuring approved under Board for Industrial and Financial Reconstruction (BIFR) and Corporate Debt Restructuring (CDR) mechanism and corporate bond restructuring. The contracting parties to a CDS may include all or any of the approved credit events Succession event: Participants may adhere to the provisions given in the Master Agreement for CDS prepared by FIMMDA. Determination Committee: The Determination Committee (DC) shall be formed by the market participants and FIMMDA. The DC shall be based in India and shall deliberate and resolve CDS related issues such as Credit Events, CDS Auctions, Succession Events, Substitute Reference Obligations, etc. The decisions of the

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Committee would be binding on CDS market participants. In order to provide adequate representation to users, at least 25 per cent of the members should be drawn from the users. Settlement methodologies The parties to the CDS transaction shall determine upfront, the procedure and method of settlement (cash/physical/auction) to be followed in the event of occurrence of a credit event and document the same in the CDS documentation. For transactions involving users, physical settlement is mandatory. For other transactions, market-makers can opt for any of the three settlement methods (physical, cash and auction), provided the CDS documentation envisages such settlement. While the physical settlement would require the protection buyer to transfer any of the deliverable obligations against the receipt of its full notional / face value, in cash settlement, the protection seller would pay to the protection buyer an amount equivalent to the loss resulting from the credit event of the reference entity. Auction Settlement: Auction settlement may be conducted in those cases as deemed fit by the DC. Auction specific terms (e.g. auction date, time, market quotation amount, deliverable obligations, etc.) will be set by the DC on a case by case basis. If parties do not select Auction Settlement, they will need to bilaterally settle their trades in accordance with the Settlement Method (unless otherwise freshly negotiated between the parties).

Accounting The accounting norms applicable to CDS contracts shall be on the lines indicated in the 'Accounting Standard AS-30 - Financial Instruments: Recognition and Measurement', 'AS- 31, Financial Instruments: Presentation' and 'AS-32 on Disclosures' as approved by the Institute of Chartered Accountants of India (ICAI). Pricing/Valuation methodologies for CDS Market participants shall use FIMMDA published daily CDS curve to value their CDS positions. Day count convention may also be decided by FIMMDA in consultation with market participants. However, if a proprietary model results in a more conservative valuation, the market participant can use that proprietary model. For better transparency, market participants using their proprietary model for pricing in accounting statements shall disclose both the proprietary model price and the standard model price in notes to the accounts that should also include an explanation of the rationale behind using a particular model over another. Prudential norms for risk management in CDS Counterparty Credit Exposures Protection seller in the CDS market shall have in place internal limits on the gross amount of protection sold by them on a single entity as well as the aggregate of such individual gross positions. These limits shall be set in relation to their capital funds. Protection sellers shall also periodically assess the likely stress that these gross positions of protection sold, may pose on their liquidity position and their ability to raise funds, at short notice.

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Computation of Credit Exposure Ceilings for all fund-based and non-fund based exposures including off-balance sheet exposures should be computed in relation to total capital as defined under the extant capital adequacy standards. The protection seller shall treat his exposure to the reference entity (on the protection sold) as his credit exposure and aggregate the same with other exposures to the reference entity for the purpose of determining various prudential limits like single / group exposure, capital market exposure, real estate exposure, exposure to NBFCs etc. Collateralization and Margining For CDS transactions, the margins would be maintained by the individual market participants. In this regard, market participants shall adhere to the following requirements: o Margins may be maintained on net exposure to each counterparty on account of CDS transactions. Till the requisite infrastructure is put in place, the positions should be marked-tomarket daily and re-margined at least on a weekly basis or more frequent basis as decided between the counterparties. Participants may maintain margins in cash or Government securities.

Protection sellers, with the approval of their Board, shall fix a limit on their Net Long risk position in CDS contracts, in terms of Risky PV01, as a percentage of the Total Capital Funds. (Net long position is the total CDS sold positions netted by the CDS bought positions of the same reference entity) Since CDS represents idiosyncratic risk on individual obligors, no netting of Risky PV01 across obligors is allowed. The gross PV01 of all non-option rupee derivatives should be within 0.25 per cent of the net worth of the banks / PDs / NBFCs as on the last balance sheet date (in terms of circular DBOD. No.BP.BC.53/21.04.157/2005-06 dated December 28, 2005). Risk Management - Role of Board and Senior Management Participants should consider carefully all related risks and rewards before entering into CDS transactions. They should not enter into such transactions unless their management has the ability to understand and manage properly the credit and other risks associated with CDS. Participants which are protection buyers should periodically assess the ability of the protection sellers to make the credit event payment as and when they may fall due. Participants should be aware of the potential legal risk arising from an unenforceable contract, e.g., due to inadequate documentation, lack of authority for a counterparty to enter into the contract (or to transfer the asset upon occurrence of a credit event), uncertain payment procedure or inability to determine market value when required.

Market Risk Exposure As regards capturing of market risk, participants may adhere to the following: The quantum of CDS protection sold (net) on a reference entity shall be taken as actual credit exposure to the reference entity and thereby would be covered under the relevant regulatory exposure limits.

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Policy requirements Before actually undertaking CDS transactions, participants shall put in place a written policy on CDS which should be approved by their respective Board of Directors. The Board approved policy on CDS should be reviewed periodically, at least once in a year. The Board approved risk management policy should cover at the minimum: The strategy - i.e., whether CDS would be used for hedging or for trading, risk management and limits for CDS; Authorization levels for engaging in such business and identification of those responsible for managing it; Procedure for measuring, monitoring, reviewing, reporting and managing the associated risks like credit risk, market risk, liquidity risk and other specific risks; Appropriate accounting and valuation principles for CDS; Determination of contractual characteristics of the product; and Use of best market practices. Reporting Requirements Trade Reporting

Market-makers shall report their CDS trades with both users and other marketmakers on the reporting platform of CDS trade repository within 30 minutes from the deal time. The users would be required to affirm or reject their trade already reported by the market- maker by the end of the day. In the event of sale of underlying bond by the user and the user assigning the CDS protection to the purchaser of the bond subject to the consent of the original protection seller, the original protection seller should report such assignment to the trade reporting platform and the same should be confirmed by both the original user and the new assignee.

Supervisory Reporting In addition to the reporting done on the trade reporting platform, the participants shall also report to their regulators information as required by them such as risk positions of the participants vis--vis their net-worth and adherence to risk limits, etc. As regards the Reserve Bank regulated entities, the information shall be reported to the respective regulatory department of the Reserve Bank on a fortnightly basis, within a week after the end of fortnight, as per the proforma given.

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