Prepared By:

Krishna Mohan Maurya

F2-13
 What is a SWAP?
Swap is a derivative in which two counterparties agree
to exchange a sequence of cash flows over a period in
the future.

Swaps are usually used to hedge risks (ex. interest rate

risk), or to speculate on changes in the underlying
prices.

Swaps can be interest rate swaps, currency swaps,

commodity swaps, equity swaps, and credit default
swaps.
 Credit Default Swaps
A Credit Default Swap (CDS) is similar to an insurance
contract, providing the buyer with protection against
specific risks associated with defaults, bankruptcy or
credit rating downgrades.
 Characteristics
CDS is the most widely traded credit derivative
product. Typical term of CDS contract is 5 years (up to
10-year CDS).

CDS documentation is governed by the International

Swaps and Derivatives Association (ISDA), which
provides standardized definitions of credit default
swap terms, including definitions of what constitutes a
credit event.
 Mechanism
One party “sells” risk and the counterparty “buys” that risk.
The “seller” of credit risk - who also tends to own the
underlying credit asset - pays a periodic fee to the risk
“buyer”.
In return, the risk “buyer” agrees to pay the “seller” a set
amount if there is a default.
Buyer pays a premium to seller so that in case of a
“negative credit event,” the seller takes on the credit risk.
If no credit default, seller pockets the premium and
everyone is happy.
 Example
Suppose Bank A buys a bond which issued by a Steel
Company.

To hedge the default of Steel Company:

Bank A buys a credit default swap from Insurance

Company C.

Bank A pays a fixed periodic payments to C, in

exchange for default protection.
Exhibit
Credit Default Swap

Credit Risk

Premium Fee
Insurance Company C
Bank A Buyer Contingent Payment On
Seller
Credit Event

Steel company
Reference Asset
 Potential Benefits
CDS help to shift risks from those who hold highly
concentrated portfolios

CDS potentially reduce borrowing costs and increases

credit supply for corporate and sovereign debtors

Use of capital more efficiently as players having excess

capital can take up credit risks
 Potential Benefits
CDS help complete markets, as they provide an
effective means to hedge and trade credit risk.

CDS allow financial institutions to better manage their

exposures, and investors benefit from an enhanced
investment universe.

 CDS spreads provide a market-based assessment of

credit conditions.
 Negative Externalities
CDS carelessly transacted can result in a concentration
of risk across a few systemically important entities
Default by counterparty A can have a significant
impact on the solvency of counterparty B
Availability of CDS has enhanced the risk appetite of
financial institutions resulting in excessive risk-taking
 Negative Externalities
CDS coupled with securitization has increased
instances of moral hazard
In recession, the likelihood of defaults increases and
the expected payoff on credit default swaps can rise
quickly.
 Credit Derivatives
Initiatives in India

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.
Conceptual issues, examined the scope for allowing
banks and financial institutions in India to use CDs
Draft guidelines on introduction of credit derivatives
were brought out on March 26, 2003 but the issuance
of final guidelines was postponed.
 Credit Derivatives
Initiatives 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)
October 24, 2007 for a second round of consultation-
global financial crisis and introduction of CDS was
postponed
 Credit Derivatives
Initiatives in India
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
 Eligible Participants
Market-makers (entities permitted to both buy and
sell protection)

Users (entities not permitted to sell protection but

permitted only to hedge the underlying risk by buying
CDS)
 Market-makers
Market-makers (both protection sellers and buyers,
subject to fulfilment of regulatory stipulations) -
permitted to hold short CDS positions

a) Commercial Banks, b) Primary Dealers, c) NBFCs

having sound financials and good track record in
providing credit facilities to borrowers, d) Insurance
Companies and e) Mutual Funds.
 Users
Users (only protection buyer to hedge underlying
exposure) - not permitted to hold short CDS
positions / sell CDS
Commercial Banks, Primary Dealers, NBFCs, Mutual
Funds, Insurance Companies, Housing Finance
Companies, Provident Funds, listed Corporates, and
any other institution permitted by the Reserve Bank.
All CDS trades shall have an RBI regulated entity
at least on one side of the transaction.
 Case study on AIG
Adversely impacting on counterparty risk.
AIG had sold CDS referenced to a huge variety of
different assets
US subprime crisis unfolded
Incurred more liabilities to fulfil collateral claims
At one point, the collateral calls on CDS exceeded
AIG’s ability to pay