Tuesday, October 6, 2009


CREDIT DEFAULT SWAP is one of the famous instruments of credit derivative, as we can understand from the name itself; it is a derivative contract which covers the credit risk. Broadly speaking credit default swap are the derivative contracts which swaps the risk of credit default from the buyer of the contract to the seller of the contract and in return the buyer of the contract have to pay some amount on regular basis, the detail condition of which is decided on negotiation of both seller and buyer of the derivative contract. In this agreement, the party that shorts credit risk is the protection buyer and pays fixed periodic payments to the party taking on the credit risk, the protection seller. Credit risk can be defined as an event when the person show his inability to fulfill his debt obligation which includes failing to pay its coupon, defaulting, or filing for bankruptcy and, if applicable, restructuring its debt. There are several contracts which contains risk element, to increase the percentage of security most of the lenders or creditors who lends money to some company/entity or invested in some institutions bond prefer to adopt the way of CDS.

It was time of early 1990 when the shape of CDS comes to existence in United States of America, the purpose was to transfer credit exposure for commercial loans and to free up regulatory capital in commercial banks, By entering into CDS, a commercial bank shifted the risk of default to a third-party and this shifted risk did not count against their regulatory capital requirements. At that time there were limited number of buyers and sellers of the contract who know each other and had in depth knowledge of the credit risk. However in a decade nearly in mid 2000 the scenario start changing and many investors get attracted towards this concept and the total meaning of security started moving towards speculation, in late 1990s the percentage of actual owners of asset or investment was more in comparison to those who were only betting on occurrence of an event, but in mid 2000 the scenario reversed totally and now the number of people betting on the occurrence were more in comparison to those who were actually holding the asset or who actually lender of money

In case of India this concept still not implemented by central bank, RBI has introduced guidelines for CDS sometime in 2007 and then withdrawn this during the financial crisis, but with the view of recovery in the world economy and insulation to Indian economy on 30 June, 2009 The Economic Times reported that the Reserve Bank of India (RBI) had sent a questionnaire to some banks seeking their views on CDS.

CDSs in most part of the world are traded in OTC (Over the Counter) markets, where trades are done over phone, which means there is no organized exchange for derivative trading, because of which we are unable to calculate the actual valuation of CDS contracts. OTC markets tend to be opaque and it is relatively difficult for regulators to keep things under check. The finance ministry has said that the best market design to reduce the risk factor of derivatives is trading of standardized products on stock exchanges or on organized exchanges.
Working of Credit Default Swap,

CDS are the derivative contracts which swaps the risk of a credit default from one person to another person, and for which the protection buyer has to pay premium to the protection seller,
There are two cases, one of which is the basic concept behind CDS that is the need of security to a credit default risk in which the protection buyer is the actual holder of asset and the other is the new evolved concept of CDS which is totally based upon speculation, which means the betting concept based upon the occurrence of a credit default event in which the protection buyer do not actually hold the asset but only bet on the occurrence of event.


An Investor named ‘A’ would like to invest 1 billion rupees in company B, which he feels suitable to use his reserved money, that will return him 10% per annum for 10 years as interest, the terms and conditions of the contract are based on negotiation of both protection buyer and seller .
The credit rating allotted to company B from a credit rating company say CRISIL is BB, which shows the below moderate level of credit default risk. But the investment policy of investor A is that he invests money only in those companies whose rating is AAA from CRISIL (example) a credit rating organization.
So to secure the risk he went to bank ‘C’ for a credit default swap contract, in which the bank will insure the risk of default of company B ,and will charge 2% per annum for the security,

In this flow chart the Bank ‘C’ is actually giving insurance to the contract between investor A and company ‘B’, Bank C is assuring the investor A about the credit payment ability of company B and charging 2% per annum as a premium amount. And after entering in to this contract bank B is now liable to pay the whole amount if any default occurs from company ‘B’.
These types of contracts are helpful for those investors who invest in moderate risk assets, investor like to pay a small amount for the safety of their investment, In this case the small amount of 2% of a billion rupees paid per year will cover the whole amount of one billion rupees, CDS basic principle is to reduce the amount of credit defaults risk, its giving a safety to the repayment of investors amount that he invested in a company.
After the initiation of the concept of credit derivatives, CDS gained highest attention among all other derivatives instruments, which resulted that the valuation of CDS in USA in year 2009 is nearly about $60 trillion dollar, which is more than the GDP of United States of America.
Changes occur in every field, to some extent they are good but beyond some extent they are bad, here is the case of CDS which change its meaning from security to mere speculation, which means now people are betting on occurrence of some specific event, now most of the CDS contract are signed by those who actually do not hold the asset, but are only betting on some credit default event based on there research or analysis.
Now take the previous example in which the investor ‘A’ invested in company ‘B’, and CDS provide the security to investor A from the credit default of company B. But changes occur day by day and now the meaning of speculation arrived, now in CASE II the investor do not really invested in company B, but actually predicting a credit default based on the research and analysis of itself or from any other source.
Now in this case the Investor A went to Bank C to buy a CDS contract based on default of company C, he neither hold any asset in company B or nor invested any amount in the company B, but his speculation is the base of contract


 Now we can see that there isn’t any line between investor and company, which shows that investor have no contracts with company B, but he is still coming under CDS contract mode only to gain expected amount which he predicted on the basis of research and analysis.
The whole working of contract is same as case I ,but in this case the investor A is not the actual holder of the asset or had invested in company A but even then he would like to enter in CDS based on speculation on company B’s valuation, for which the investor will like to pay 2% of the contract value per year as premium and then if company B becomes bankrupt or become default or what it may be the specific event of the contract then the bank C is liable to pay the specific amount of CDS contract.
The terms and conditions of the contract is based upon the quality of valuation team of both investor and bank, after calculating the valuation they negotiate with each other to land on the terms and condition of contract . Every institution, investor or a common individual want to maximize there profit , so the whole profit or we can say the result is depend upon the valuation team and the negotiation skills while dealing with the other party of contract .
Every Concept has its positive and negative side both, the dealing manner of these contracts is creating an issue in front of all economist and market researchers, because of OTC trading method we can not calculate the actual amount of CDS working in the market, so it will create hurdles in valuation of an asset. Let’s take the above example, we do not have any idea about how many CDS contracts are running with the Company B, suppose the valuation committee of Bank C valued company B worth around 15 Billion rupees and many other banks which are at present in CDS contract with company B valued same in past and signed CDS contract because they are not aware of how many banks are at present in contract with company B, and now the company B declare the bankruptcy, now which bank can claim on its assets, At last the whole chain of banks and institution which were connected with the default company will have to bear a loss of amount of CDS contract.
Not only the OTC is a negative part of CDS but also the policy of banks dealing in CDS also define the risk factor in this market, Even if a bank who usually sign CDS contracts, without taking care of its liabilities start signing more and more CDS contracts will come under the problem in near future if some CDS contracts file defaults.
When a Bank comes under a CDS contract, usually have to put the CDS amount in spare to overcome the future expected liability. But most of the banks usually don’t opt this principle and sign more and more contracts without making reserves of contract amount, which will in turn give more problems in near future, for example Bank C signed 30 CDS contracts in a year, which include both assets holder (security) and non holder (speculation) contracts, and in the period of 2 years 15 CDS contracts which were signed by bank C filed bankruptcy then the loss that should be bear by bank C will be huge and can create the Bank C ‘s bankruptcy. So not only the OTC but the policies of bank matter very much, and can say that the workforce who are engaged in the process of valuation are also matter indirectly in case of credit default swaps market, there vision can make or destroy the whole structure of bank who engaged in CDS market.
India is famous in the whole world for her financial policies, Reserve bank of India which is the central bank of India had taken various measures to keep Indian economy insulated from the financial crisis, and succeeded to some extent, which resulted the GDP growth of India for year 2008-09 at 6.7% which was quite better as compare to other countries.
The lending policy of Indian banks are free from credit ratings, most of the lending is done on the basis of past records or valuation of balance sheet, which may vary from bank to bank .Now with the introduction of CDS the lending policy will going to shift towards the organized policies based on credit points awarded to the company which will help to synchronize the whole lending market of the country.
In India CDS market will going to create a new sector of trading, where a person can swap his credit default risk to other person on the basis of negotiated conditions, In India CDS are planned to be traded in organized exchanges, which will reduce some amount of risk of CDS contracts, as we can put an eye on the number of contracts from a particular bank and also to a particular company, it will be helpful in both the actual valuation of the company and liquidity of bank. While trading in OTC mode no one can judge the amount of contracts signed by one bank, and also it is difficult to calculate the actual valuation of the company, because in OTC mode we don’t have any idea about how many contracts are running on one company or on one asset.
That’s the only good point in Indian scenario that all the CDS contracts can be checked easily and efficiently, which will help to increase the accuracy in Valuation of any asset or any company, and also by CDS contracts there will be a suitable and organized lending market for India.
The idea of introducing derivatives in an exchange-traded format has support from independent experts as they say it will mitigate the risk to the system. The presence of the clearing house will act as a pillar for all transactions which will help to keep volume in synchronized with the risk the system can take.
But the chain default threat is still there, that if a one company claim bankruptcy then the whole chain related to that company will have to face problem. In our previous example, if company B files bankruptcy than the bank C has to pay the amount to investor A and it will reduce the liquidity of bank C, which in return reduces the financial strength of the company and bank C may have to fill bankruptcy.
Now we can see that there is a risk for Indian economy with CDS contracts but they are also new methods to create and maintain the organized lending sector in India, Indian banking sector is now started moving towards changes and started adopting new modes of growth and creating new ways to increase the banking business, CDS contract to some extent will be highly beneficial for the banking sector with this banks will explore untapped methods of earnings, not only for the banking sector but also for the investors of the country CDS’s are going to reduce the credit risk factor of investments .
The risk factor of OTC will not be the case with India because the central bank has decided to open derivative exchanges for CDS and all other derivative instruments. Which will reduce most of the demerits related to CDS contracts, and that’s the reason that most of the economists and market researcher are giving green signal to the CDS opening in India.
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