Credit Default Swap-Vs Girish
-
Upload
shwetika-gupta -
Category
Documents
-
view
215 -
download
0
Transcript of Credit Default Swap-Vs Girish
-
7/28/2019 Credit Default Swap-Vs Girish
1/2
Credit & Derivatives
34 T H E B A N K I N G & F I N A N C I A L W O R L DJune 201
Come October 24, Indian corporatehouses and banks will have a new tool intheir hands to manage credit risk the CreditDeault Swap or CDS. From the highso 2007, when the outstanding notionalamount on CDS was around 63 rillion USD,it has come down to around USD 27 rillionas o May 20th, 15.4 trillion single name,10.26 o index and 2.27 tranche. Someexperts have blamed the CDS or the globalnancial crisis. Te Banking & FinanceWorld brings you an overview o the CDS.
What is a CDS?Markit, the leading provider o CDS
market data denes CDS as a creditderivative transaction in which two partiesenter into an agreement, whereby one party(the Protection Buyer) pays the other party(the Protection Seller) periodic paymentsor the specied lie o the agreement. TeProtection Seller makes no payment unlessa credit event relating to a predeterminedreerence asset occurs. I such an eventoccurs, it triggers the Protection Sellerssettlement obligation, which can be either
cash or physical. India will ollow physicalsettlement.
A CDS is like an insurance policy. Inan insurance policy, the insurance rmpays the loss amount to the insured party.Similarly, the buyer o the CDS the bank orinstitution that has invested in a corporatebond issue seeks to mitigate the losses itmay sufer on account o a deault by thebond issuer. Credit deault swaps allow oneparty to buy protection rom another
party or losses that might be incurred aa result o deault by a specied reerencinstrument a bond issue in India. Tbuyer o protection pays a premium to thseller, and the seller o protection agreeto compensate the buyer or losses incurreupon the occurrence o any one o severaspecied credit events. Tus CDS oferthe buyer a chance to transer the credirisk o nancial assets to the seller withouactually transerring ownership o the assetthemselves.
Example:Suppose State Bank o India invests i
INR 100 crore bond issued by Essar SteelSBI wishes to hedge losses that may arisrom a deault o Essar Steel. SBI can buy credit deault swap rom,say, J P MorganSBI will pay xed periodic payments to J PMorgan, in exchange or deault protection
Te JargonProtection Buyer is the bank or nancia
institution which has invested in a corporat either a bond or as credit and who wishe
to hedge the credit risk. Te buyer pays thpremium. SBI in our example.
Protection Seller is the Bank oFinancial Institution which is willing to ofethe insurance against losses sought by thbuyer. Te seller receives the premium. JMorgan in our example.
Reerence Credit the specic loan obond or which protection is sought. TEssar Bond in our example.
Credit Event or rigger event T
Credit Default Swap A Primer
The new instruments of risk dispersion have enabled the largest and mostsophisticated banks in their credit-granting role to divest themselves ofmuch credit risk by passing it to institutions with far less leverage.
- Allan Greenspan
Girish V S
A CDS islike aninsurancepolicy. In aninsurancepolicy, theinsurancefrm pays
the lossamount to
the insuredparty
-
7/28/2019 Credit Default Swap-Vs Girish
2/2
Credit & Derivatives
35T H E B A N K I N G & F I N A N C I A L W O R L DJune 2011
enor Reers to the duration o a CDcontract.
ier reers to level o debt in the capitastructure o the reerence entities. Tere canbe our tiers, each representing a diferenlevel o seniority in liquidation. Each tiewill have a diferent CDS protection.
Senior Subordinated Junior PreferredUpront Reers to the initial lump
sum payment made when entering a CDtransaction. Upront payments are madwhen the credit quality o the reerencentity is poor.
Use of CDSCDS can be used by protection buyer
to hedge their credit exposure and b
protection sellers to participate in credimarkets, without actually owning assets.Te protection buyer can transer credi
risk on an entity without transerring thunderlying instrument, reap regulatorbenet in terms o lower capital charge, seereduction o specic concentrations in crediportolio and go short on credit risk.
Te protection seller will be able tdiversiy his portolio, create exposure ta particular credit, have access to an assewhich may not otherwise be available anincrease the yield on his portolio.
Apart rom the above, CDS help Bankstotransferrisktootherristakers, so banks can make more loans.
Distribute risk widely throughouthe system and prevent concentrations orisk.
Provide important informatioabout credit conditions, helping bankerand policymakers to supervise traditionabanking activities.
Serve signaling functionCDprices are reported to produce better anmore timely inormation.
Risks in CDSIn a CDS transaction, the risks assume
by the protection buyer and protection selleare not symmetrical.
Te protection buyer gives up the risk odeault by the reerence entity, but takes onthe risk o simultaneous deault by both thprotection seller and the reerence credit.
Te protection seller takes on the deaulrisk o the reerence entity.
event that will cause the buyer o protectionto invoke the claim against the seller. Forexample, a bank may have specied that itscorporate customer should not issue urtherdebt. In case the corporate should issueurther debt, it becomes a trigger event andthe bank will invoke the CDS protection
can ask the seller or the money. Te triggerevent is usually bilaterally determined. ISDAdocumentation provides or six types otrigger events
Bankruptcy Failuretopay Restructuring Repudiation/moratorium ObligationAcceleration ObligationdefaultHowever the market in USA generally
looks at only the rst three.Notional Amount - reers to the par value
o credit protection bought or sold, INR100 Crores in our example. Te premiumpayment calculations or each paymentperiod and the recovery amounts in theevent o a deault depends on the notionalamount.
CDS Spread Spread is also called apremium. Tis is the amount paid by theProtection Buyer to the Protection Seller.Te spread is denominated in basis pointsand is paid quarterly. For example i thespread or Essar is 100 basis points, SBI willpay J P Morgan 100 basis points multipliedby INR 100 Crores (the notional o the
trade) annually. Te amount will be paid inour equal tranches in advance.
Credit Spread Curve is the curvegenerated by the credit spread or a uniquereference entity/tier/currency/docclausecombination over diferent tenors.
Recovery Rate is the estimatedpercentage o par value that bondholderswill receive ater a credit event. In the US ora AAA bond it was 40%.
Reerence Entity is the legal entity thatis the subject o a CDS contract. Te reerenceentity can be the issuer or the guarantor o
the debt. In our example it is Essar Steel.Reerence Obligation is the specicbond issue that is reerenced in the CDScontract
Settlement is the exchange o cash orthe reerence obligation in case o a creditevent. RBI has specied that settlementshould physical delivery. Te substitutiono cash instead o physical delivery was thecause o the large speculative positions inthe global CDS market.
CDS canbe used byprotectionbuyers tohedgetheir creditexposureand byprotection
sellers toparticipate
in creditmarkets,withoutactuallyowningassets