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Sambalpur University A dissertation submitted as part of the requirements for the Degree of Master of Business Administration ON

“The Role of Credit Default Swap in minimising Credit Risk”

Under the Guidance of: Submitted By: Mrs. P. Gahan. Professor, Finance Sambalpur University Burla (orissa)

Nishit Parmar 6th Trimester Regd. No. 18041/03 Roll No: 1407MBA59

Department of

Business Admistration S a m b a l p u r U n i v e r s i t y , J y o t i V i h a r- 7 6 8 0 1 9

A STUDY OF CREDIT DEFAULT SWAP DISSERTATION 2009

Submitted in the partial fulfillment of the requirement For the award of DEGREE OF MASTER OF BUSINESS ADMINISTRATION

SUBMITTED BY:

NISHIT PARMAR ROLL NO.-1407/MBA/59

UNDER THE GUIDENCE OF PROF. P.GAHAN

DEPARTMENT OF BUSINESS ADMINISTRATION

SAMBALPUR UNIVERSITY BURLA

Certificate

This is to certify that the Dissertation entitled (A STUDY OF CREDIT DEFAULT SWAP WITH SPECIAL REFERENCE TO MINIMISATION OF CREDIT RISK) and submitted by NISHIT PARMAR having roll no1407/MBA/59 for the partial fulfillment of the requirements of the MBA BATCH 2007-09, embodies the bonafide work done by him under our supervision.

……………………………. …............... Signature of the guide

………

Place…………………. Date………………….

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Declaration

I do here by declare that this piece of Dissertation project Report on Credit Derivatives, entitled “Credit Default Swap, transfer of risk and its importance”submitted by me to Sambalpur University, in partial fulfillment of the requirement for the award of degree of “Master of Business Administration” is a product of our own.

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ACKNOWLEDGEMENT

With profound veneration, first of all we recline ourselves before ALMIGHTY without whose blessings ourselves is cipher. It is my pleasure to be indebted to various people, who directly or indirectly contributed in the development of this work and who influenced my thinking, behavior, and acts during the course of study. As a student specializing in finance, I came to know about the ground realities in topics like Credit Default Swap. For this I am indebted to Mrs.P.Gahan, Faculty, Dept. of Business Administration who took personal interest in my project and bore the associated headaches It would be unfair if I do not mention the name of Dr.A.K.D.M, who gave me valuable tips to complete this project and my friends for their inspiring presence and blessings. Lastly, I would like to thank the almighty and my parents for their moral support and my colleagues with whom I shared my day-to-day experience and received lots off suggestions that improved my work quality. Signature ----------------------Name: NISHIT PARMAR

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Executive Summary Recent awareness of the need to manage credit risks has spurred the development of credit derivatives. These products allow Financial institutions to reduce or eliminate their credit risk. A broad range of credit derivatives is now available, each structured to meet a specific aim. Default swaps are derivative contracts in which one counterparty(the “Buyer” of protection) pays a premium to a second party( the “Seller” of protection) for taking credit risk to an issuer or a security(the “Reference Issuer”). The second party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If the Reference Issuer suffers a “credit event”, generally an event of default, then the seller of protection pays the loss on the Reference Security to the Buyer, and the swap then terminates. The size of the payment is usually linked to the decline in the reference asset’s market value following the credit event. This particular dissertation paper looks at the history behind the CDS market, the factors which influenced its growth, its advantages and so on. Moreover it also look at the current state of the global market and the trajectory of its arrival to this point, including the types of credit traded, the most popular products in the market, etc. Then, there is a market survey-- its findings, objectives and scope and limitations of this widely used credit instrument. Finally, the paper ends with interesting facts, case study and appendix file.

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CONTENTS i)

ACKNOWLEDGEMENT……………………………………… 5

ii)

EXECUTIVE SUMMARY…………………………………….. 6

CHAPTER 1: INTRODUCTION …………………………………………. 8 i)

Background of credit derivative market

ii)

Types of credit derivate instrument

iii)

Credit default swap

iv)

Terminology used

v)

Significance and mechanism so on….

CHAPTER II: LITERATURE REVIEW.................................................... 30 CHAPTER III: RESEARCH METHODOLOGY........................................34 CHAPTER IV: DATA ANALYSIS AND INTERPRETATION. ………………39

i)

Knowledge of credit derivative instrument

ii)

Various types of risk

iii)

Risk transfer through CDS

CHAPTER V: SUGGESTIONS AND CONCLUSION ………………….46 CHAPTER VI : LIMIATATIONS ……………………………………

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BIBLIOGRAPHY

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Chapter1.

Introduction Global derivative market Credit risk Types of credit derivative products Credit default swap

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The Credit Derivative Market Credit derivatives are tools for the full or partial transfer of credit risk. Credit derivatives first appeared in the United States in the early 1990s. They are instruments that can be used to transfer all or part of the credit risk on a third party, or “reference entity”, by means of a contract between two counterparties. The key innovation of credit derivatives is that they allow market participants to sell the credit risk on a claim whilst retaining legal ownership of the claim, in other words, continuing to record it on the balance sheet. Conversely, they enable other participants to buy that credit risk without systematically having to bear the financing cost and interest rate risk associated with acquiring or holding the claim. This ability to “synthetically” transfer a claim, by decoupling credit risk from the actual claim, affords greater flexibility in credit risk management to both the risk seller (or protection buyer) and the risk buyer (or protection seller). This growth in the credit derivatives market has been driven by an increasing realization of the advantages credit derivatives possess over the cash alternative, plus the many new possibilities they present to both credit investors and hedgers. The recent expansion of the market in credit derivatives is a major highlight in the world of investment banking. The amounts outstanding in these instruments rose from $200 billion in 1997 to $800 billion in 2000, a four-fold increase in as many years.

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As their name implies, credit derivatives offer bankers a new way of operating in the credit market, which has grown as a result of three main factors. First, the deregulation of European markets and the advent of monetary union has resulted in greater liquidity and more competition, creating a truly homogenous European credit market. Second, given the low level of nominal interest rates, final investors are willing to take on more credit risk to boost returns. And in the aftermath of the recent crises in Asia and Russia, the need to hedge and evaluate these investments has become patently clear. Third, the regulatory authorities are set to accept the use of internal models for measuring risk. This will enable banks to better identify and measure credit risk and therefore manage it more effectively.

Credit derivatives, an instrument that emerged around 1993-94, is a part of the market for financial derivatives. Since credit derivatives are presently not traded on any of the organized exchanges, they are a part of the over-the-counter (OTC) derivatives market. Though still a relatively small part of the huge market for OTC derivatives, credit derivatives are growing faster than any other OTC derivative, the reasons for which are not difficult to understand. Credit derivatives are derivative contracts that seek to transfer defined credit risks in a credit product or bunch of credit products to the counterparty to the derivative contract. The counterparty to the derivative contract could either be a market participant, or could be the capital market through the process of securitisation. The credit product might either be exposure inherent in a credit asset such as a loan, or might be generic credit risk such as bankruptcy risk of an entity. As the risks, and rewards commensurate with the risks, are transferred to the counterparty, the counterparty assumes the position of a virtual or synthetic holder of the credit asset.

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Credit Risk: the challenge of our times Credit risk is the risk inherent in credit, and credit is the very basis of our present society. Our present society lives on credit and rests (this word might be quite a misnomer!) on credit. From governments to the marginal consumer, every one increases current spending power based on credit. Credit allows us to consume far more than our current earnings sustain. Therefore, credit is the very basis of consumerism. Credit is the driving force of the World economy. Credit is parting with value today against a promise for value in future. Credit risk is the risk that the promise may be broken. Obviously therefore, credit risk is the most important economic risk facing the society. Over the post 10 years or so, the global economy has seen ballooning of credit. In practice, there is one crucial difference between a bond issued by a company and one issued by a government, namely the level of solvency. An investor who lends toa private enterprise considers that the risk of default is greater than if he were lending to a government. So he will demand a higher rate of interest to compensate for that risk. The credit differential – or spread – between these two issuers will thus depend on the probability of either one defaulting during the life of the bond. It should be noted that a spread is also defined the difference between the corporate debt rate and the swap rate in the bank financing market. Furthermore, by purchasing a risky (or "default able") bond and immunizing the portfolio against interest rate risk, the investor is then exposed solely to the issuer's credit risk via fluctuations in its spread. The spread thus becomes a financial instrument in its own right, in almost exactly the same way as an interest rate. Credit derivatives are over-the-counter contracts which allow the isolation and management of credit risk from all other components of risk.

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Interest Rate risk

V volatility risk

Credit risk FX risk

Credit Derivatives Products Credit default products are the most commonly traded credit derivative product and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations . Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives.

I.

Unfunded credit derivatives

An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets. 12

This format is also termed ‘unfunded’ format because the investor makes no upfront payment. Subsequent payments are simply payments of spread and there is no principal payment at maturity.

This includes: • • • •

II.

Credit default swaps (CDS) Credit spread options (CSO), Total rate of return (TROR) swaps First-to-default (FTD) swaps

Funded credit derivatives

However, quite often, for various reasons, parties may convert a credit derivative into a funded product. This may take various forms, such as: Protection seller prepays some kind of estimate of protection payments to the protection buyer, to be adjusted against the protection payments, if any, or else, returned to the protection seller; Protection seller places a deposit or cash collateral with the protection buyer which the latter has a right to appropriate, in case of protection payments. Protection buyer issues a bond or note which the protection seller buys, with a contingent repayment clause entitling the protection buyer to adjust 13

the protection payments from the principal, interest, or both, payable on the bond or note. The purpose of converting an unfunded derivative into a funded form may be variegated: it could either be a simple collateralization device for the protection buyer, or may be creation of a funded product which features a derivative and is therefore a restructured form of the original obligation with reference to which the derivative was initially written

A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. The advantage of this to the protection buyer is that it is not exposed to the credit risk of the protection seller . Funded credit derivatives chiefly comprise one type of instrument:– Credit-linked notes (CLN), which are “linked” to a claim and are issued by the protection buyer with options on the default risk of the claim. Here, the protection seller receives interest payments that recognize the “composite” nature of the note, and in return agrees to be repaid only the note’s market value if a credit event affects the underlying asset to trade the risk in the form of a credit linked note.

Credit Default Swap Credit default swap can literally be defined as an option to swap a credit asset for cash, should it default. A credit default swap is essentially an option, and option bought by the protection buyer, and written by the protection seller. The strike price of the option is the par value of the reference asset. Unlike a capital market option, the option under a credit default swap can be exercised only when a credit event takes place.

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In other words, CDS are swap contracts in which the buyer makes a series of payments to the seller in return for protection intended to hedge against a default of a credit instrument such as a bond. Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff if the company defaults within a certain period of time, while the “protection seller” collects periodic payments for assuming the risk of default.

CDSs are used to transfer credit risk from one party to another without exchanging the securities that underlie the contract. The purchaser of a CDS is buying protection against credit events affecting the reference security. A Credit Default Swap (CDS) is an over-the-counter, tradable, credit derivative contract that is similar to an insurance policy. The CDS is a bilateral contract in which one party (usually known as the protection buyer) pays a fee or premium to another party (generally referred to as the protection seller) to protect against a financial loss it may incur if a credit event (usually a default) occurs with respect to the underlying bond issuer (reference entity). Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.

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CDS- its origin, size and players involved Credit Default Swaps were invented in 1997 by a team working for JPMorgan Chase. 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. The CDS market has been almost doubling annually since it began in earnest in 1996. And there are as yet no signs of a slowdown. With a number of emerging market financial crises, particularly Asia and Russia, and an unprecedented fall in corporate credit quality in both the US and Europe, CDSs have been well tested in the past ten years. The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market

A. Size According to the International Swap and Derivatives Association (ISDA), the total notional amount of interest rate and currency derivatives as of the end of 2003 stood at $142.3 trillion, while the total notional amount of credit default swaps outstanding was $3.58 trillion, or about 2.4% of the overall derivatives market. As recently as 2000, credit derivatives accounted for just 1% of the derivatives market globally. As a further sign of growth, now the credit derivatives market has surpassed the size of the equity derivatives market, which stood at $3.44 trillion at the end of 2003.

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B. Players The largest players in the CDS market are: Commercial Banks- Traditionally, a bank’s business has involved credit risk as it originates loans to corporations. The CDS market offers a bank an attractive way to transfer risk without removing assets from its balance sheet and without involving borrowers. Further, a bank may use CDSs to diversify its portfolio, which often is concentrated in certain industries or geographic areas. Insurance companies: are increasingly becoming dominant participants in the CDS market, primarily as sellers of protection, to enhance investment yields. Insurers also invest heavily in so-called “structured credit” products, such as credit link notes (CLNs) and collateralized debt obligations (CDOs). Globally, insurance companies had net sold positions of $137 billion in 2003.

Investment banks: Investment banks are also active participants in the CDS market, both as providers of liquidity for their customers and as proprietary traders. The CDS market can offer a highly efficient means of removing assets from the balance sheets of investment banks, an objective that has become more and more important in recent years as the leading investment banks seek to offer a ‘one-stop shopping service’ to their corporate clients. Given the relatively limited size of investment banks’ capital, the CDS market provides them with a useful means of demonstrating their commitment to corporate clients by supporting syndicated lending facilities without exerting unsustainable strains on their balance sheets.

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Buyers

Banks Hedge Funds Insures/Reinsurers Pension Funds

Securities Firms Corporates Mutual Funds Government

CDS- terminology • CREDIT: In the context of the capital market, the asset class known as ‘credit’ means different things to different people. But in recent years, it has often been used as a generic term to describe the non-government or nonpublic sector bond market. In the context of the derivatives market, however, the ‘C’ in CDS can, and often does, refer to issuers of securities that would not fall into this category – such as triple-A rated governments that are prolific and regular issuers in the international capital market.

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• DEFAULT: In a sense, the use of the term ‘default’ in the context of the credit derivatives market can be misleading, since a default is not actually required for a credit default swap to be triggered. The term default is additionally misleading because it implies that the use of instruments such as credit default swaps is restricted to instances in which banks or investors are exposed to highly risky credits. There is also a very active market in CDSs written on individual names or credits in which neither the buyer nor the seller of protection believes there is the remotest possibility of default. In that sense, ‘default’ can often be a misnomer.

• SWAP: The use of the word ‘swap’ can also be misleading, with ‘contract’ perhaps a better way of describing the arrangement reached by the buyer and seller of protection. As a report published in June 2001 by Banc of America Securities explains: “The product name reflects its genesis within traditional (ie, interest rate) swap groups, and their use of traditional swap documents to also document credit default swaps. Nonetheless, the product’s name – credit default swap – is a misnomer… A CDS is not really a swap in the way most of the credit spread markets think of swaps – that is, as swaps of fixed for floating cash flows, as is the case of interest rate swaps. In the case of credit default swaps, there is only a ‘swap’ in the instance when a credit event triggers a compensating payment.”

•Premiums: Premium prices – also known as fees or default swap spreads – are quoted in basis points per annum of the contract’s notional value. Usually, predetermined premiums are paid by the buyer of protection to the seller on a quarterly basis, with the contract terminating either at maturity or at the time of a credit event occurring. In the case of those distressed credits in which the CDS market remains open, however, it has become more usual for sellers of credit protection to demand the payment of an upfront premium as opposed to the standard running spread.

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•Protection buyer: The protection buyer is the entity that seeks protection against the risk of default of the reference obligation. The protection buyer may usually be a bank or financial intermediary which has exposure in credit assets, funded or unfunded. In such a case, the primary objective of a protection buyer is to hedge against the credit risks inherent in credit assets. In short, hedges the default risk on the reference asset

•Protection seller: The protection seller is mainly motivated by yield enhancement, or getting to earn out of synthetic exposures where direct creation of loan portfolios is either not possible or not feasible. In OTC transactions, the protection sellers are insurance companies, banks, hedge funds, equity funds, investment companies, etc. In case of capital market transactions, the securities are mostly rated, and the investors that take up these securities are based on investment objectives of the investor concerned. The protection seller may be taking a trading view and expecting the credit quality of the reference entity to improve. In short, earns investment income with no funding cost gains customized, synthetic access to the risky bond

•Credit Events: The occurrence of the specified credit event will trigger the termination of the credit derivative contract and transfer of the default payment from the protection seller to the protection buyer. The credit events will normally be agreed by the parties as a combination of: • Bankruptcy - where the reference entity becomes subject to a winding up, administration, receivership or analogous insolvency proceeding (Chapter 11 in the US), • Failure to pay - where the reference entity fails to make a payment of interest or principal on an obligation when due,

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• Obligation Acceleration - where a reference entity’s obligation is accelerated by reason of an event of default, • Obligation Default – where the reference entity defaults on one of its obligations, •Down-grade in S&P/Moody’s credit rating below a specified minimum level, • Repudiation/Moratorium where the reference entity repudiates or a moratorium is declared over some or all of its debts, • Restructuring - where the reference entity arranges for some or all of its debts to be restructured causing a material adverse The credit event notice specifies that a credit event has occurred and gives the facts relevant to that determination. The notice of publicly available information (which is usually incorporated in the credit event notice) cites publicly available information from an agreed number of public sources (usually two), such as Bloomberg and the Financial Times, confirming facts relevant to the credit event’s determination.

CDS- Features The CDS can do almost everything that cash can do and more. We list some of the main features of CDS below■ They can be tailored made to meet the specific requirements of the entity. ■ The CDS has revolutionized the credit markets by making it easy to short credit. ■ CDS are unfunded so leverage is possible. This is also an advantage for those who have high funding costs, because implicitly lock in Libor funding to maturity. 22

■ CDS can be used to take a spread view on a credit, as with a bond. ■ Dislocations between cash and CDS present new relative value opportunities. This is known as trading the default swap basis. ■ CDS are off-balance sheet instruments. ■ They are flexible instruments and are OTC products. Thus, credit derivatives can be an important instrument for banks and bond portfolio managers as well as active investors such as hedge funds.

CDS- Significance • Regulatory capital treatment-- Regulated financial institutions, such as banks and insurance companies, are commonly subject to minimum capital requirements imposed by governments and regulators to protect the financial system against systemic collapse and market shocks (regulatory capital requirements). These requirements force a regulated institution to hold minimum levels of capital against its risk exposure. Credit derivatives can allow financial institutions to continue to hold debt, while reducing the amount of capital they must hold against the debt for regulatory capital purposes. The reduced capital allocation arises from the protection afforded by the credit derivative. •Risk management- credit derivatives not only make risk management more efficient but flexible too by allocating the credit risk to most efficient manager of that risk. A financial institution’s desire to limit and/or diversify credit risk concentrations in its debt portfolios can make credit derivatives an attractive proposition and useful tool.

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• Risk separation- credit derivatives like CDS allow for separation of credit risk from other risk of the assets. Fundamentals to the growing acceptance of CDSs is the transfer of risk away from the balance sheets of banks and towards the much broader capital market, which is generally recognized as being more skilled and disciplined in terms of assessing and pricing credit risk. • CDS create liquidity- The CDS add depth to the secondary market of underlying credit instruments which may not be liquid for variety of reasons. •Hedging--A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract. This may be preferable to selling the security outright if the investor wants to reduce exposure and not eliminate it, avoid taking a tax hit, or just eliminate exposure for a certain period of time • Speculation—The other use for speculators to "place their bets" about the credit quality of a particular reference entity. With the value of the CDS market, larger than the bonds and loans that the contracts reference, it is obvious that speculation has grown to be the most common function for a CDS contract. CDS provide a very efficient way to take a view on the credit of a reference entity. An investor with a positive view on the credit quality of a company can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on the company's bonds. An investor with a negative view of the company's credit can buy protection for a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has some other credit event

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• Stabilizing effect - The fact that the defaults by Enron, WorldCom and Argentina did not lead to more serious financial difficulties at individual banks or to any chain reactions in the banking sector is considered to be largely due to the use of credit derivatives on these debtors. The markets also digested other large credit events (see table) quite successfully by making use of credit derivatives. Top 10 credit events in CDS market Reference entity 1.) Worldcom 2.) Enron 3.) Marconi 4.) Railtrack 5.) Xerox 6.) Argentina 7.) Teleglobe 8.) Pacific Gas & Electric 9.) Swissair 10.) AT&T Canada Source: Fitch, 09/2003

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How does it really work? Credit derivatives are financial instruments that isolate, and then transfer to investors, the credit risk generated in lending transactions. These investors act as protection sellers, agreeing to cover the cost if a pre-defined credit event occurs. For taking on the credit risk, the seller receives a payment from the protection buyer. While all credit derivatives are based on this principle, they differ as regards the specified credit event (payment default, restructuring, deterioration in creditworthiness etc.), the number and kind of underlying financing transactions (bank credit or bonds) and the form of derivative (option, forward, swap). As described above, in a credit default swap, the buyer and the seller of protection enter into a contract where the protection buyer pays a fixed premium for protection against a certain “credit event,” such as a bankruptcy of the reference entity, or a default on debt issued by the reference entity. Usually there is no exchange of money when two parties enter in the contract, but they make payments during the term of the contract, thus explaining the term credit default “swap.” A. CDS Spreads The premium paid by the protection buyer to the seller, often called “spread,” is quoted in basis points per annum of the contract’s notional value and is usually paid quarterly. Note that these spreads are NOT the same type of concept as “yield spread” of a corporate bond to a government bond. Rather, CDS spreads are the annual price of protection quoted in bps of the notional value, and not based on any risk-free bond or any benchmark interest rates.

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B. Contract Size and Maturity There are no limits on the size or maturity of CDS contracts. However, most contracts fall between $10 million to $20 million in notional amount. Maturity usually ranges from one to ten years, with the 5-year maturity being the most common tenor. C. Trigger Events ISDA’s standard documents for CDS provide for six kinds of trigger events. However, market participants generally view the following three to be the most important: · Bankruptcy · Failure to Pay · Restructuring D. Pricing In the early days of the CDS market, pricing of contracts was more an art than a science. Today, however, pricing is more quantitatively based, using parameters such as, (1) the likelihood of default, (2) the recovery rate when default occurs, and (3) some consideration for liquidity, regulatory, and market sentiment about the credit. In theory, CDS spreads should be closely related to bond yield spreads, or excess yields to risk-free government bonds.

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Example of 5 years, US$ 100 million company Vaishalli priced at 100 bp per annum. Protection Buyer

Protection Seller

Premium 100 bp p.a. for 5 years

If credit event occurs Protection Buyer

US$ 100 million

Protection seller

US$ 100 million XYZ nominal

In What Way is Compensation Made? Settlement arises when the credit events take place. The first step taken after a credit event occurs is a delivery of a “Credit Event Notice,” either by the protection buyer or the seller. Then, the compensation is to be paid by the protection seller to the buyer via either: (1) Physical settlement, or (2) Cash settlement, as specified in the contract.

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Physical Settlement: In a physical settlement, the protection seller buys the distressed loan or bond from the protection buyer at par. Here the bond or loan purchased by the seller of protection is called the “deliverable obligation.” Physical settlement is the most common form of settlement in the CDS market, and normally takes place within 30 days after the credit event. Thus, in case of physical settlement, there is a transfer of the reference obligation to the protection seller upon events of default, and thereafter, the recovery of the defaulted asset is done by the protection seller, with the hope that he might be able to cover some of his losses if the recovered amount exceeds the market value as might have been estimated incase of a cash settlement.

Cash Settlement: In case of cash settlement, the losses computed as discussed above are paid by the protection seller to the protection buyer, and the reference asset continues to stay with the protection buyer. The payment from the seller of protection to the protection buyer is determined as the difference between the notional of the CDS and the final value of the reference obligation for the same notional. Cash settlement is less common because obtaining the quotes for the distressed reference credit often turns out to be difficult. A cash settlement typically occurs no later than five business days after the credit event.

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Chapter 2.

Literature review

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Introduction to Credit Derivatives Vinod Kothari

Credit derivatives, an instrument that emerged around 1993-94, are a part of the market for financial derivatives. Since credit derivatives are presently not traded on any of the organised exchanges, they are a part of the over-thecounter (OTC) derivatives market. Though still a relatively small part of the huge market for OTC derivatives, credit derivatives are growing faster than any other OTC derivative, the reasons for which are not difficult to understand. Credit derivatives are derivative contracts that seek to transfer defined credit risks in a credit product or bunch of credit products to the counterparty to the derivative contract. The counterparty to the derivative contract could either be a market participant, or could be the capital market through the process of securitisation. The credit product might either be exposure inherent in a credit asset such as a loan, or might be generic credit risk such as bankruptcy risk of an entity. As the risks, and rewards commensurate with the risks, are transferred to the counterparty, the counterparty assumes the position of a virtual or synthetic holder of the credit asset. In the market for equities and bonds, investors may acquire exposure to either a single entity’s stocks or bonds, or to a broad-based index. The logical outcome of the increasing popularity of credit derivatives was credit derivatives indices. Thus, instead of gaining or selling exposure to the credit risk of a single entity, one may buy or sell exposure to a broad-based index, or sub-indices, implying risk in a generalized, diversified index of names. The counterparty to a credit derivative product that acquires exposure to the risk synthetically acquires exposure to the entity whose risk is being traded by the credit derivative product. Thus, the credit derivative trade allows people to trade in the generic credit risk of the entity, without having to trade in a credit asset such as a loan or a bond.

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Given the fact that the synthetic market does not have several of the limitations or constraints of the market for cash bonds or loans, credit derivatives have become an alternative parallel trading instrument that is linked to the value of a firm – similar to equities and bonds. Coupled with the device of securitisation, credit derivatives have been rendered into investment products. Thus, investors may invest in credit linked notes and gain credit exposure to an entity, or a bunch of entities. Securitisation linked with credit derivatives has led to the commoditization of credit risk. Apart from commoditization of credit risk by securitisation, there are two other developments that seem to have contributed to the exponential growth of credit derivatives – index products and structured credit trading. In the market for equities and bonds, investors may acquire exposure to either a single entity’s stocks or bonds, or to a broad-based index. The logical outcome of the increasing popularity of credit derivatives was credit derivatives indices. Thus, instead of gaining or selling exposure to the credit risk of a single entity, one may buy or sell exposure to abroad-based index, or sub-indices, implying risk in a generalized, diversified index of names. Quite often, the development of the hedge fund industry has been associated with the development of credit derivatives. Hedge funds are prominent in credit derivatives trades, particularly in case of the lower tranches of the structured credit spectrum. The hedge fund industry represents the segment of investor capital that is least regulated, risk neutral, out to seize opportunities arising out of mispricing, etc. As the credit derivatives trades are almost completely unregulated and offer opportunities of short trades in credit not permitted by the bond market, the credit derivatives industry provides an excellent playing ground to the hedge funds.

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Our present society lives on credit, and rests (this word might be quite a misnomer!) on credit. From governments to the marginal consumer, every one increases current spending power based on credit. Credit allows us to consume far more than our current earnings sustain. Therefore, credit is the very basis of consumerism. Credit is the driving force of the World economy. Credit is parting with value today against a promise for value in future. Credit risk is the risk that the promise may be broken. Obviously therefore, credit risk is the most important economic risk facing the society. Over the post 10 years or so, the global economy has seen ballooning of credit. The development of credit derivatives is a logical extension of the evergrowing array of derivatives trading in the market. The concept of a derivative is to create a contract that transfers some risk or some volatility. This risk or volatility may relate to the price or performance of a reference asset, event, a market price or any other economic or natural phenomenon. Such trade in risk does not mean a trade in the reference asset. The reference may remain with someone who is a complete stranger to the derivative contract. However, the derivative trade closely mimics and risks and returns of holding the underlying asset, or at least a segment thereof. Thus, derivatives bring about a completely independent trade in the risks/returns of an asset. For example, a trade in options or futures in equities may run completely independent of trades in equity shares. Credit derivatives apply the same notion to a credit asset. Credit asset is the asset that a provider of credit creates, such as a loan given by a bank, or a bond held by a capital market participant. A credit derivative enables the stripping of the loan or the bond, from the risk of default (or more risks, depending on the nature of the derivative), such that the loan or the bond can continue to be held by the originator or holder thereof, but the risk gets transferred to the counterparty. The counterparty buys the risk obviously for a premium, and the premium represents the rewards of the counterparty.

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Much of the significance that credit derivatives enjoy today is because of the marketability imparted by securitisation. Credit derivatives would have mostly been a closely-held esoteric market, but for the introduction of securitisation device to commodities a credit derivative and bring it to the capital market. Securitised credit derivatives, or synthetic securitisation, are a device of embedding acredit derivative feature into a capital market security so as to transfer the credit risk into the capital markets. In case of synthetic securitisations, the protection against the risk is ultimately provided by the capital markets. The synthesis of credit derivatives with securitisation methodology has complemented each other. Credit derivatives have acquired a new meaning when they were turned into marketable securities using securitisation techniques; securitisation on the other hand got new impetus by opening up possibilities of keeping a whole portfolio of credit assets on books and yet transfers the credit risks of the portfolio. Lot of erstwhile securitizes over Europe and Asia are preferring synthetic securitisations to cash transfers. The feedstock of a credit derivative transaction is a credit asset, that is to say, an asset or contract that gives rise to a relationship of a creditor and debtor. However, credit derivatives are usually not related to a specific credit asset but trade in the generic risk of default of a particular entity. The entity whose risk of default is being traded in is commonly referred to as the reference entity. There are cases where the credit derivative is linked not to the general default of the reference entity but the default of specific asset or portfolio of assets. This is called the reference obligation, reference asset or the reference portfolio. The party that wants to transfer the credit risks is called the protection buyer and the party that provides protection against the risks is called the protection seller. The two are mutually referred to as the counterparties. Protection buyer and protection seller may alternatively be referred to as the risk seller and the risk buyer respectively.

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Chapter 3.

Research Methodology

35

RESEARCH METHODOLOGY

The purpose of research is to discover answers to the questions through the application of scientific procedures. The main aim of research is to find out the truth which is hidden and which has not been discovered as yet. Though each research study has its own specific purpose, we may think of research objectives as falling into a number of following broad categories:

 To gain familiarity with a phenomenon or to achieve new insights into it.  To portray accurately the characteristics of a particular individual, situation or a group.  To determine the frequency with which something occurs or with which it is associated with something else.  To test a hypothesis of a casual relationship between variables.

Research methodology is a way to systematically solve the research problem . it may be understood as a science of studying how research is done scientifically. In it we study the various steps that are generally adopted by a researcher in studying his research problem along with the logic behind them.

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Research methodology has many dimensions and research methods do constitute a part of the research methodology. The scope of research methodology is wider than that of research methods. Thus, when we talk of research methodology we not only talk of the research methods but also consider the logic behind the methods we use in the context of our research study and explain why we are using a particular method or technique and why we are not using others so that research results are capable of being evaluated either by the researcher himself or by others. Why a research study has been undertaken, what data have been collected and what particular method has been adopted, why particular technique of analyzing data has been used and a host of similar other question are usually answered when we talk of research methodology concerning a research problem or study. Research is often described as active; diligent and systematic process of inquiry aimed at discovering, interpreting and revising facts. This intellectual investigation produces a greater understanding of events, behaviors or theories and makes practical application through laws and theories. In other words we can say, the purpose of research is to discover answers to the questions through the application of scientific procedures. The main aim of research is to find out the truth which is hidden and which has not been discovered as yet. Research methodology is a way to systematically solve the research problem. It may be understood as a science of studying how research is done scientifically. In it we study the various steps that are generally adopted by a researcher in studying his research problem along with the logic behind them.

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OBJECTIVE The main objective of the research is to understand the concept of credit default swap(cds). What is the definition of credit default swap. Why they are increasing? What are the causes of CDS? How we can price this thing? Overall the major objectives of applying the research methodology are to achieve the following objectives: 1. 2. 3. 4. 5. 6. 7.

understand the concept of risks-its meaning and types, segregate credit risk from other types of risks, importance of credit risk, different means of minimizing/eliminating credit risk, understanding credit derivative market, using credit default swap –popular method, and role of CDS in the credit derivative market.

To carry out my project I have used the descriptive research.

Descriptive research includes surveys and fact-finding enquiries of different kinds. The major purpose of descriptive research is description of the state of affairs, as it exists at present. The main characteristic of this method is that the researcher has no control over the variables; he can only report what has happened or what is happening. It is also called as ex post facto research. Most ex post facto research projects are used for descriptive studies in which researcher seeks to measure such items as, for example, frequency of shopping, preferences of people, or similar data. Descriptive research also 38

includes attempts by the researcher to discover causes even when they cannot control the variables. The methods of research utilized in descriptive research are survey methods of all kinds.

WHY DESCRIPTIVE RESEARCH? In this case descriptive study was most suitable because it helped in giving focus to the preferences, knowledge, beliefs & satisfaction of a group of people in a given population and characteristics of the successful and unsuccessful companies. Moreover it helped in determining the relationships between two or more variables.

DATA SOURCE To carry out the project work I have consulted the various secondary sources of data such as Magazines, Journals and websites.

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Chapter 4.

Data Analysis & Interpretation

40

The analysis of data collected is done through percentage method and the result is interpreted analyzing all the relevant tables. A. Knowledge of credit derivative instrument Table-1 Yes

60

No

24

Never

16

yes no never Slice 4

The knowledge of credit derivative instrument is known to the commercial banks and they are aware of this widely used derivative instrument (60%) so as to minimize the risk.

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B. Aware of credit default swap Table – 2 yes

no

Never

18

68

14

70 60 50 40

CDS 3-D Column 2 3-D Column 3

30 20 10 0

yes

no

never

It is clear from the data that most of them don’t have any idea about Credit Default Swap(CDS) i.e. around (68%). In other words, the use of credit default swap is limited in use.

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C. Risk transferred Table- 3 Yes 16

No 12

80 70 60 50 40 30 20 10 0

Don’t Know 72

Risk transferred 3-D Colum n 2 3-D Colum n 3

yes

never

Thus it is clear from the data that the banks doesn’t know how to minimize the credit risk with the help of credit default swap.

D. Instruments widely used by the banks Table -4 Securitization

67

Credit derivative instrument

13

Guarantee

20

43

securitization credit derivative guarantee Slice 4

So with the help of the survey it is clear that the most widely used instrument to transfer credit risk by the banks used is securitization (67%) In comparison to other instrument like credit derivative(13%) and guarantor(20%).

E. Knowledge of AIG, Freddie Mae and Lehman Brother Table- 5 AIG Freddie Mae Lehman Brother

45 12 43

44

45 40 35 30 25 20 15 10 5 0

know ledge 3-D Colum n 2 3-D Colum n 3 AIG

Lehm an Brother

Thus it is known that the investment banks like Lehman Brother (43%) And insurance giant AIG around (45%) is well known as compare to Freddie Mae.

F. Most important risk Table- 6 Credit Risk

37

Volatility Risk

11

FX Risk

24

Market Risk

28

45

credit volatility FX Market

Out of the different types of risk the most weightage is given to the credit(37%) and Market risk (28%) in comparison to volatility (11%) and FX Risk ( 24 %). Thus the credit risk occupies a great proportion of the risk.

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Chapter 5

Suggestions & Conclusion

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Suggestions After all these points, I just want to say that CDS a big problem of banks. Due to this crisis the CDS also increased. That’s why all the banks are facing problems. My recommendations are: 1. Strengthening provision norms and loan classification standards based on forward looking criteria (like future cash flows) were implemented. 2. Through securitization they can reduce credit risk. 3. Speed of action- the speedy containment of systematic risk and the domestic credit crunch problem with the injection of large public fund for bank recapitalization are critical steps towards normalizing the financial system. 4. Strengthening legal system 5. Maintain required capital adequacy ratio as per basel 2 norms. That means now the provision for NPL will be more. This may look a conservative approach. But it should be implemented to reduce risk. 6. Modification in accounting system 7. Use the concept of credit derivative 8. Aligning of prudential norms with international standard.

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Conclusion We have seen just how quickly and how decisively CDS have established themselves as one of the leading financial securities available currently. And this is just the beginning. Academics and market professionals are working to structure more and more complex, more and more comprehensive products to suit the needs of every type of investors. Even in its short history, CDSs have weathered more than one storm, and passed with flying colours. A look at the pricing of the CDSs shows the difficulties in accurately pricing them. However, several complex new models have been developed to provide pricing accuracy. We have not looked at them here owing to space constraints. It is now universally accepted that in the hands of investors who properly comprehend the working of credit derivative instruments, securities like CDS present an excellent opportunity to manage and hedge credit risk. We also looked at how CDSs have historically been the harbinger of corporate failure or turnarounds with equal accuracy. The benefit of credit derivatives are ease of capital adequacy requirements, building of a balanced portfolio, smoother client relationships for the beneficiary (the protection buyer), a good source of revenues for the guarantor and increased and better deployment of funds at the macroeconomic level, from the point of view of the overall financial system.

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Chapter 6.

Limitations

50

Limitations During the survey the following limitations were found, they are as follows:

• Unfamiliarity with derivatives • Conservatism • Derivative horror stories • Lack of focus on financial risk management • Large exposures and concentrations within individual portfolios may become increasingly difficult to identify • Scarcity of specific investment expertise.

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BIBLIOGRAPHY Papers/Articles Skora, Richard. K- The credit default swap JP Morgan- the JP Morgan guide to credit derivates BARRA- Improving performance with credit default swaps Deutsche Bank research- credit derivatives: effects on the stability of financial system The Lehman Brothers- Guide To Exotic Credit Derivatives

Internet Websites Kothari,V: Credit Derivates: A primer- http://www.creditderiv.com/creprime.hmt Credit derivative guidehttp://db.riskwaters.com/public/showPage.html?page=11370

Books Kothari, V: credit derivative and synthetic securitization- A guide to commoditization of credt risk S.L. Gupta : Financial derivatives theory concepts and problems

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An INNOVATIVE INSTRUMENT FOR MINIMISING CREDIT RISK (Please put a tick mark in the appropriate Box) 1. Are you aware of the credit derivative instrument?

Yes

No

Never

2. Have you heard about credit default swap(CDS)

Yes

No

Never

3. Does credit risk is transfer through CDS?

Yes

No

Never

[

4. Mark the instrument which you know the bank uses for securing its credit risk?

Securitisation Credit derivative instrument Guarantee 5. Why there is a boom of bond debt market in recent years?tick the one you prefer.

CDS Guarantee

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Collateral debt obligation 6. Have you heard about AIG,freedie mae,lehman brother?

Yes

No

Never

7. Does CDS reduce credit risk? Yes

no

never

8. Which risk is the most important for commercial bank? Credit risk Volatility risk FX risk Market risk

9. Enron(a U.S company) investors were saved due to....

Securitisation CDS Guarantee Don’t know 10.Do you think CDS is one of the factor for economic meltdown 2007?

Yes

no

no idea

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11.Warren buffet has said “derivative instruments are time bomb”.comment

___________________________________________________________________________ ___________________________________________________________________________ _______

NAME OF THE BANK: ADDRESS: THANKING YOU” for your kind cooperation with regards Nishit Parmar. MBA(TRIM-VI), Sambalpur University

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