New microsoft word dfd

New microsoft word dfd

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  2. Conceptual Aspectsof Credit Derivatives 2.1 The origin of credit derivatives can be traced back to the securitisation of mortgaged- back market of 1980s. In securitisation, the credit risk was hedged only by eliminating the credit product from the books of credit provider altogether. The credit derivative, in the present form, was formally launched by Merrill Lynch in 1991 (with USD 368 million). However, the market did not grow much till 1997. The size of the market was USD 40 and 50 billions respectively in 1996 and 1997. The market has now acquired a critical mass of over USD one trillion, half of which is concentrated at London. The average transaction size is between USD 10 to 25 million and the average tenor, which was less than two years, has now gone up to five years. However, there are only a few active players in the market and the secondary market is still illiquid. Definition 2.2 Credit derivatives are over the counter financial contracts. They are usually defined as ―off-balance sheet financial instruments that permit one party (beneficiary) to transfer credit risk of a reference asset, which it owns, to another party (guarantor) without actually selling the asset‖. It, therefore, ―unbundles‖ credit risk from the credit instrument and trades it separately. Credit Linked Notes (CLNs), another form of credit derivative product, also achieves the same purpose, though CLNs are on- balance sheet products. 2.3 Another way of describing credit derivative is that it is a financial contract outlining potential exchange of payments in which at least one leg of the cash flow is linked to the ―performance‖ of a specified underlying credit sensitive asset. Characteristic Features 2.4 The characteristic features of credit derivative are as under: Credit derivative is a contract between two counterparties. One is the credit risk protection buyer or beneficiary and the other is the credit risk protection seller or guarantor. (ii) The protection buyer or beneficiary pays a fee, called premium as in insurance business, to protection seller or guarantor.
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  (iii) The referenceasset for which credit risk protection is bought and sold is pre- defined. It could be a bank loan, corporate bond / debenture, trade receivable, emerging market debt, municipal debt, etc. It could also be a portfolio of credit products. (iv) The credit event for which protection is bought or sold is also pre-defined. It could be bankruptcy, insolvency, payment default, delinquency, price decline or rating downgrade of the underlying asset / issuer. (v) The settlement between the protection buyer and protection seller on the credit event can be cash settled. It could also be settled in terms of the physical financial asset (loan or bond, etc.). If the protection seller is not satisfied with the pricing or valuation of the asset in the credit event, it has the right to ask for physical settlement. (vi) Credit derivatives use the International Swaps and Derivatives Association (ISDA) master agreement and the legal format of a derivative contract. (i) Types of Credit Derivatives 2.5 Credit derivatives can be divided into two broad categories: (a) Transactions where credit protection is bought and sold; and (b) Total return swaps. (a) Transactions Where Credit Protection Is Bought And Sold It is a bilateral derivative contract on one or more reference assets in which the protection buyer pays a fee through the life of the contract in return for a contingent payment by the protection seller following a credit event (e.g. failure to pay, credit rating downgrade, etc.) of Page 3 of 36 Report on Credit Derivatives. the reference entities. Credit default swap is an example of a credit derivative transaction where credit protection is bought and sold. In a Credit Default Swap (CDS), one party agrees to pay another party periodic fixed payments in exchange for receiving ―credit event protection‖, in the form of a payment, in the event that a third party or its obligations are subject to one or more pre-agreed adverse credit events over a pre-agreed time period. Typical credit events include bankruptcy, failure to pay, obligation acceleration, restructuring, and repudiation/moratorium. It is the CDS market’s convention to refer to the party that makes the periodic payments for credit event protection as the Protection Buyer. Conversely, the party that provides the credit event protection is referred to as the Protection Seller. The
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  third party andthe specific obligation, if any, on which credit event protection is concurrently bought and sold are referred to as the Reference Entity and Reference Obligation, respectively. In most instances, the Protection Buyer makes quarterly payments to the Protection Seller. The periodic payment is typically expressed in annualized basis points of a transaction’s notional amount. In the instance that no pre-specified credit event occurs during the life of the transaction, the Protection Seller receives the periodic payment in compensation for assuming the credit risk on the Reference Entity/Obligation. Conversely, in the instance that any one of the credit events occurs during the life of the transaction, the Protection Buyer will receive a compensating payment. The form of the compensation will depend on whether the terms of a particular CDS calls for a physical or cash settlement. In a physically settled transaction, the buyer of protection would deliver the reference obligation (or an obligation of equal or higher payment priority) to the Protection Seller and receive the face value of the Reference Obligation. Alternatively, in a cash settled transaction, the Protection Seller makes a cash payment to the Protection Buyer based on a formula that the two parties agree upon at the inception of the contract. Generally, the formula specifies that the Protection Seller pays the Protection Buyer the difference between par and the then prevailing market value of a Reference Obligation following one of the specified credit events. In some cases, the cash payment is a fixed amount decided at the inception of the contract. The CDS is discussed in greater details in Appendix A. The other such credit derivatives are credit default option and credit linked notes. If the fee is paid fully in advance, the transaction is referred to as a credit default option. If the credit default swaps or options are embedded in a bond issuance, it is called a credit linked note. In this case, the investor in the credit linked note is the protection seller, while the issuer is the protection buyer. The interest rate risk and liquidity risk of the reference assets remain with the protection buyer until maturity or occurrence of a credit event, whichever is earlier. (b) Total Return Swaps Total Return Swaps (TRS) are bilateral financial contracts designed to synthetically replicate the economic returns of an underlying asset or a portfolio of assets for a pre- specified time. One counterparty (the TR payer – the protection seeker) pays the other counterparty (the TR receiver – the protection provider) the total return of a specified asset, the referenceobligation. In return, the TR receiver typically makes regular floating payments. These floating payments represent a funding cost of the TR payer. In effect, a TRS contract allows
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  the TRS receiverto obtain the economic returns of an asset without having to fund the assets on its balance sheet. As such, a TRS is a primarily off-balance sheet financing vehicle. When the underlying obligation is a fixed income instrument, the total return payment would consist of interest, fees (if any), and any change in the reference obligation’s value. Any appreciation or depreciation in the reference obligation’s value is typically determined on the basis of a poll of dealers. TRS contracts can specify that change-in-value payments be made either on a periodic interim basis (which will reduce the credit risk between the two parties to the contract) or at maturity. Should the underlying asset decline in value by more than the coupon payment, the TRS receiver must pay the negative total return, in addition to the funding cost, to the TRS payer. At the extreme, a TRS receiver can be liable for the extreme loss that a reference asset may suffer following, for instance, the issuing company’s default. In instances when change-in-value payments are to be made at the maturity, the change-in- value payment is sometimes physically settled. In such cases, the TR payer physically delivers the reference obligation to the TR receiver at the maturity of the TRS contract in return for cash payment of the reference obligation’s initial value. Since a TRS frequently requires periodic exchanges of cash flows based in part on a mark-to- market of the underlying asset, the reference asset of a TRS is typically liquid and traded asset. When illiquid assets are referenced, alternate pricing arrangements are used. A TRS’s reference obligation can be a single asset—such as a particular bond or loan—or an index or basket of assets. TRS that reference baskets of credits or indices are becoming increasingly common due the cost-effective access they provide to portfolios of credit risk. That is, index-based TRS provide investors with their desired portfolio exposure while eliminating the cost of executing a large number of individual cash transactions to obtain it.
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  The maturity ofthe TRS does not have to match the maturity of the reference obligation, and in fact is usually shorter than the maturity of the underlying asset. Though shorter in maturity, the TRS receiver is naturally exposed to full duration exposure of the underlying asset. In a number of instances, TRS are drafted to allow either party to cancel the transaction at the anniversary date of the contract. In most instances, TRS referencing a single name typically terminate upon default of the underlying asset or other such defined credit events. At such time, the asset can be delivered and the price shortfall paid by the TR receiver. A TRS can continue despite default or other credit event if the TR receiver posts the necessary collateral. 2.6 In contrast to credit default swaps—which only transfer credit risk—a TRS transfers not only credit risk (i.e. the improvement or deterioration in credit profile of an issuer), but also market risk (i.e. any increase or decrease in general market prices). In addition, TRS contrasts with CDS since payments are exchanged among counterparties upon changes in market valuation of the underlying and not only upon the occurrence of a credit event as is the case with CDS contracts. 2.7 The different types of credit derivatives, viz., Credit Default Swaps (CDS), Credit Linked Deposits (CLDs), Credit Linked Notes (CLNs), Repackaged Notes, Collateralised Debt Obligations (CDOs), etc. are discussed in greater details in Appendix A. 3. Need and Scope for Credit Derivatives in India Benefits from Credit derivatives 3.1 One of the more successful products introduced in India in the recent past has been the Interest Rate Derivative product. Currently, there has been an increase in the use of this product with a number of hedging benchmarks and the entry of a large number of market players. The success of this product is due to the fact that it has helped the market to transmit the interest rate risk from one participant to another. This transmission of the interest rate risk allows for the risk to be hedged away by the risk averse players and reside in players who are risk takers and /or those who are able to bear the risk.
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  3.2 Similarly, creditrisk also requires an effective transmission mechanism. It is now imperative that a mechanism be developed that will allow for an efficient and cost effective transmission of credit risk amongst market participants. The current architecture of the financial market is either characterized by lumpiness in credit risk with the banks and development financial institutions (DFIs) or lack of access to credit market by mutual funds, insurance companies, etc. 3.3 The major hedging mechanism now available with banks and DFIs to hedge credit risk is to sell the loan asset or the debentures it holds. Banks and Development Financial Institutions require a mechanism that would allow them to provide long term financing without taking the credit risk if they so desire. They could also like to assume credit risk in certain sectors / obligors. 3.4 On the other side, investors, including banks and DFIs, would also be looking for additional yields. In an environment of declining yields, investors would welcome mechanisms where they can earn an additional yield by taking on credit risk. There exists now in India an investor base, which can be segmented along tenor lines. The mutual fund industry has investment appetite in the short end - upto 5 years, the banking industry has appetite in the middle segment - between 5 and 8 years, while the insurance companies have appetite at the very long end - over 8 year band. It is now necessary to have a mechanism that will allow credit risk to be extracted from portfolios, tranched according to tenor and risk profile (i.e. credit rating) and transferred to those agents that are most comfortable holding the credit risk with the appropriate characteristics. 3.5 Credit derivatives will give substantial benefits to all kinds of participants, including the financial system as a whole, such as: § Banks would stand to benefit from credit derivatives mainly due to two reasons – efficient utilisation of capital and flexibility in developing/ managing a target risk portfolio. Currently, banks in India face two broad sets of issues on the credit leg of their asset – blockage of capital and loss of opportunities, for example:
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  (i) (ii) Banks generally retainassets – and hence, credit risk – till maturity. This results in a blocking up of bank’s capital and impairs growth through churning of assets. Due to exposure norms that restrict concentration of credit risk on their books, banks are forced to forego attractive opportunities on existing relationships. § Asset portfolio of banks is largely constrained by distribution system and sales relationships. New banks possess capital but have to overcome high costs in building an asset portfolio. Similarly, existing banks may want to diversify portfolio but may be unable to do so because of stickiness of client relationships and switching costs. 3.6 Credit derivatives would help resolve these issues. Banks and the financial institutions derive four main benefits from credit derivatives; viz: § Credit derivatives allow banks to transfer credit risk and hence free up capital, which can be used in productive opportunities. Banks can conduct business on existing client relationships in excess of exposure norms and transfer away the risks. For example, a bank which has hit its exposure limits with a client group may have to turn down a lucrative guarantee deal under current scenario. But, with credit derivatives, the bank can take up the guarantee and maintain its exposure limits by transferring the credit risk on the guarantee or previous exposures. This will allow banks to maintain client relationships. Banks can construct and manage a credit risk portfolio of their own choice and risk appetite unconstrained by funds, distribution and sales effort. Banks can acquire exposure to, and returns on, an asset or a portfolio of assets by simply writing a credit protection. Credit risk would be diversified – from ―banks/DFIs alone‖ to other players in the financial markets and lead to financial stability. § § §