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Derivatives A derivative in financial parlance refers to an asset whose value is determined or rather derived from another underlying asset,

or event. The concept of a derivative is very old though the name derivative is quite modern. Any kind of a wager, a bet is a derivative where the participants value of gain and loss is dependent on some underlying event like winning a match. The first formal derivative was traded in the form of forward contracts on the Chicago Board of Trade in 1851 for 3,000 bushels of corn. This was the first of its kind in the derivatives segment, since then the derivatives market has seen phenomenal growth. Credit Derivatives Credit derivatives are financial contracts that allow the transfer of credit risk from one market participant to the other, without transferring the ownership, potentially facilitating greater efficiency in the pricing and distribution of credit risk among market participants. Thus credit derivatives separate the ownership and management of credit risk from other qualitative and quantitative aspects of ownership of financial assets. Credit derivatives give banks an alternate way of handling the risk in their portfolio. While traditionally they could only lend and hold their credit portfolio, securitization provided banks with an avenue to lend and sell their loan portfolio but at the cost of jeopardizing its relationship with the borrower. Credit derivatives enable banks to lend and hedge without affecting their relationship with the customer and effectively handle the credit risk in their portfolio. Types of Credit Derivatives Credit derivatives can be categorized on the basis of the number of participants in the deal, the funding of the derivatives and the entity on whom the swap is written. Credit derivatives can be classified as: Single name credit derivatives or, Multi-name credit derivatives Single name credit derivatives: It involves protection against default by a single reference entity. The various types of single name credit derivatives are Credit Default Swaps (CDS), Total Return Swaps and credit spread put options. Multi-name credit derivatives: It allows investors to transfer some or all of the credit risk associated with a portfolio of defaultable securities as against dealing with each security in the portfolio separately. First-to-default basket swap, portfolio default swap, synthetic collateralized debt obligations are different kinds of multi-name instruments.

The various types of credit derivatives are as follows: 1) Credit Default Swaps (CDS) A credit default swap is a bilateral financial contract in which a counterparty (the protection buyer) pays a periodic fee , expressed in fixed basis points on the notional amounts to the protection seller in return for a payment contingent upon the default of a third party reference credits. Thus the protection buyer pays a periodic fee to the other party, the protection seller, during the term of the CDS. This fee called the credit spread is the internal rate of return that equates the expected premium flows over the life of the swap to the expected loss if a default occurs at various dates. In case a credit event occurs, then the protection seller is obligated to compensate the protection buyer for the loss by means of a specified settlement procedure. The settlement could be either physical settlement or cash settlement. The credit event is generally defined to cover events like failure to pay, bankruptcy, insolvency, restructuring, repudiation or moratorium, obligation acceleration and obligation default, rating downgrade, change in credit spread above an agreed level etc.

2) Total Return Swap (TRS) A swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment. In a total return swap, the party receiving the total return will receive any income generated by the asset as well as benefit if the price of the asset appreciates over the life of the swap. In return, the total return receiver must pay the owner of the asset the set rate over the life of the swap. If the price of the assets falls over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price. Illustration: The two counterparties are labelled as banks, but the party termed Bank A can be another financial institution, including cash-rich fixed-income portfolio managers such as insurance companies and hedge funds. In the figure, Bank A has contracted to pay the total return on a specified reference asset, while simultaneously receiving a Libor-based return from Bank B. The reference or underlying asset can be a bank loan such as a corporate loan or a sovereign or corporate bond. The total return payments from Bank A include the interest payments on the underlying loan, as well as any appreciation in the market value of the asset. Bank B will pay the Libor-based return; it will also pay any difference if there is any fall in the price of the asset. The economic effect is as if Bank B owned the underlying

asset, as such TR swaps are synthetic loans or securities. A significant feature is that Bank A will usually hold the underlying asset on its balance sheet, so that if this asset was originally on Bank Bs balance sheet, this is a means by which the latter can have the asset removed from its balance sheet for the term of the TR swap. If we assume Bank A has access to Libor funding, it will receive a spread on this from Bank B. Under the terms of the swap, Bank B will pay the difference between the initial market value and any depreciation, so it is sometimes termed the guarantor while Bank A is the beneficiary.

3) Credit Spread Option It is a financial derivative contract that transfers credit risk from one party to another. An initial premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level. The buyer of a credit spread option will receive cash flows if the credit spread between two specific benchmarks widens or narrows. Credit spread options come in the form of both calls and puts, allowing both long and short credit positions. Credit spread options can be issued by holders of a specific company's debt to hedge against the risk of a negative credit event. The buyer of the credit spread option (call) assumes all or a portion of the risk of default, and will pay the option seller if the spread between the company's debt and a benchmark level (such as LIBOR) grows. There are two primary types of credit options: Put option: where the option writer agrees to compensate the option buyer for a decline in the value of the financial asset below the strike price. These credit options are specified in terms of the acceptable default spread of a bond. Therefore in case of exercise of the credit option, the payoff is determined by subtracting the market price of the bond from the strike price, with the strike price being determined by taking the present value of the bonds cash flow discounted at the risk free rate plus the strike credit spread.

Call options: This option is structured so that the option is in the money when the credit spread exceeds the specified (strike) spread level. The payoff is the difference in the credit spread times a specified notional value.

4) Asset swaps Asset swaps combine an interest-rate swap with a bond and are seen as both cash market instruments and also as credit derivatives. They are used to alter the cash flow profile of a bond. The asset swap market is an important segment of the credit derivatives market since it explicitly sets out the price of credit as a spread over Libor. Pricing a bond by reference to Libor is commonly used and the spread over Libor is a measure of credit risk in the cash flow of the underlying bond. Asset swaps can be used to transform the cash flow characteristics of reference assets, so that investors can hedge the currency, credit and interest rate risks to create synthetic investments with more suitable cash flow characteristics. An asset swap package involves transactions in which the investor acquires a bond position and then enters into an interest rate swap with the bank that sold him the bond. The investor pays fixed and receives floating. This transforms the fixed coupon of the bond into a Libor based floating coupon. Example: Consider an entity that wishes to insure against loss to due to credit events such as default or bankruptcy of the issuer of a bond it is holding. As a protection buyer holding this risky bond, it wishes to hedge the credit risk of this position. By means of an asset swap the protection seller will agree to pay the protection buyer Libor +/- a spread in return for the cash flows of the risky bond (there is no exchange of notional at any point). In the event of default the protection buyer will continue to receive the Libor +/- a spread from the protection seller. In this way the protection buyer has transformed its original risk profile by changing both its interest rate and credit risk exposure.

5) Credit Linked Notes (CLN) Credit Linked Note is a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. A CLN is normally a bond that has been issued using a medium term note programme. It is the direct obligation of the issuer but it contains additional credit risks for the buyer. The principal repayment is linked not only to creditworthiness of the issuer but also a third party known as the reference entity. Provided the reference entity experiences no credit event during the life of the CLN the principal will be repaid to the investor on maturity. During the life of the note the investor will also have received regular interest payments, (coupons). Framework of Credit Linked Notes: Let's suppose your bank issues medium term notes and wants to structure a CLN. How is it put together? Typically the bank would select a reference entity and would then sell protection using a credit default swap, (CDS), on that selected reference entity. Selling protection would mean the bank received a regular fixed payment from the CDS counterparty. The bank now issues the CLN. The CLN would be for the same principal amount and maturity as the CDS. The final terms of the CLN would mirror the terms in the CDS transaction. The CLN investor would pay cash to the bank to buy the note. The bank would pay the investor regular interest until the maturity of the note. (Diagram 1)

Diagram 1

Provided there is no credit event by the reference entity the investor receives back the principal investment on the maturity of the note. (Diagram 2)

Diagram 2 What happens if the reference entity experiences a credit event? The investor will experience a credit loss, this is what happens: 1. The CDS on which the bank sold protection is triggered. The bank pays to the CDS counterparty the principal amount of the CDS in cash. The bank receives in return a deliverable instrument normally a bond that was issued by the reference entity that is now in default. 2. The CLN is also triggered. The investor does not get his principal returned, instead the bank on-delivers the bond to the CLN buyer (Diagram 3)

Diagram 3

6) Collateralised Debt Obligations (CDO) A CDO is a special purpose company or vehicle (SPV), complete with assets, liabilities and a manager. Typically, the CDOs assets consist of a diversified portfolio of illiquid and creditrisk assets such as high yield Bonds (CBO) or bank leverage loans (CLO)

Simple CDO Structure:

We have set up a typical CDO structure in the figure above. The assets are transferred to the SPV that funds these assets, from cash proceeds of the notes it has issued. The CDO structure allocates interest income and principal repayment from a pool of different debt instruments to a prioritised collection of securities notes called tranches. Senior notes are paid before mezzanine and lower rated notes. Any residual cash flow is paid to the equity piece. This makes the senior CDO liabilities significantly less risky than the collateral. On every payment date, equity receives cash distributions after the scheduled debt payments and other costs have been paid off. The equity is also called the first-loss position in the collateral portfolio. This is because it is exposed to the risk of the first dollar loss in the portfolio. The CDO rating is based on its ability to service debt with the cash flows generated by the underlying assets. The debt service depends on the collateral diversification and quality guidelines, subordination and structural protection (credit enhancement and liquidity protection). As we move down the CDOs capital structure, the level of risk increases. The equity holders that bear the highest risk have the option to call the transaction after the end of the non-call period, which in most cases lasts three to five years. The typical CDO consists of a ramp -up period, during which the collateral portfolio is formed, a reinvestment period, during which the collateral portfolio is actively managed, and an unwind period, during which the liabilities are repaid in order of seniority using collateral principal proceeds. During the reinvestment phase, the equity class distributions consist of excess interest on the full portfolio, minus collateral interest income remaining after the payment of debt interest and other fees. The manager would reinvest collateral principal proceeds. In the repayment period, excess interest payments gradually decrease as the collateral portfolio principal proceeds are used to repay the debt in order of seniority. After all the debt classes have been redeemed, and if the equity class has not elected to call the transaction, the remaining principal payments pass to the equity.

Credit Derivatives: Initiatives in India

Introduction of credit derivatives in India was actively examined in the past to provide the participants tools to manage credit risk in their portfolio. A Working Group on introduction of credit derivatives in India was constituted in 2003 with membership from banks, insurance companies and related departments in the Reserve Bank. The Group dealt with conceptual issues, examined the scope for allowing banks and financial institutions in India to use credit derivatives and submitted its report in March 2003. Based on the recommendations of the Working Group, draft guidelines on introduction of credit derivatives were brought out on March 26, 2003. However, taking into account the status of the risk management practices then prevailing in the banking system, the issuance of final guidelines was deferred.

Subsequently, the matter was revisited in the Annual Policy Statement for the year 2007-08 wherein it was indicated that as a part of the gradual process of financial sector liberalisation in India, credit derivatives would be introduced in a calibrated manner. To begin with, it was decided to permit commercial banks and primary dealers (PDs) to deal in single-entity Credit Default Swaps (CDS). Accordingly, draft guidelines were issued on CDS on May 16, 2007 and based on the feedback received, a revised draft was again placed for comments on October 24, 2007 for a second round of consultation. However, the status was reviewed in the wake of the global financial crisis and introduction of CDS was kept in abeyance so as to be able to draw upon the experience of developed countries. The matter has since been reviewed and the Second Quarter Review of Monetary Policy of 2009-10 has proposed introduction of plain vanilla OTC single-name CDS for corporate bonds for resident entities subject to appropriate safeguards. To begin with, all CDS trades will be required to be reported to a centralised trade reporting platform and in due course, they will be brought on a central clearing platform. Two Indian banks were parties to the first credit default swap (CDS) transaction in India. ICICI Bank bought insurance from IDBI Bank to protect its lending to Rural Electrification Corp. The deal came soon after the Reserve Bank of India gave the final green signal at the end of November for these credit derivative products. RBI Guidelines relating to CDS As per guidelines, foreign institutional investors (FIIs), banks, insurers, NBFCs, listed companies, housing finance companies, provident funds and primary dealers can buy credit protection under the scheme. The RBI said that beside banks, the NBFCs and primary dealers with a net owned fund of Rs 500 crore will be permitted to act as market makers. The guidelines further said that entities will only be allowed to buy CDS contracts to hedge credit risk and not for speculation.