Credit+Derivatives+Final

8/3/2019 Credit+Derivatives+Final

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CREDIT DERIVATIVES-the concepts, instruments

and the future


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RISK MANAGEMENT

MAJOR TYPES OF RISK:

Market Risk

Credit Risk

Market Risk : Movement in interest rates, stock

prices, commodity prices , exchange rate

which effect the value of the firm.

Can be managed by entering into offsetting or

hedging transcations.


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CREDIT RISK

Risk that counterparties to the transaction willfail to make the obligated payment.

Also called default risk

Initial method of Credit Risk reduction:Limiting the amount of business with a party

Requiring minimum counterparty creditratings

Periodically marking contracts to market,requiring collateral.


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While these methods reduce risk they are notadequate to manage credit risk.

Managing risk does not always mean reducing

or eliminating risk. In some cases assumption ofcredit risk is desirable.

In recent years great deal of attention onseparating market risk from credit risk.

In 90s an innovation in credit risk managementappeared on the scene..

CREDIT DERIVATIVES


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CREDIT DERIVATIVES

ORIGIN: Securitization of mortgage back market of 1980s

Launched in the present form by Merrill Lynch in 1991(with US$368 million) The market did not grow much till 96(USD 40 Billion)

From 1996 to 2000 the market has grown from

$40B

to

$810B

Presently the market exceeds USD 1trillion, half in London

Only a few active players and secondary market is illiquid.


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DEFINITION

Credit derivatives are over the counter financialcontracts. They are usually defined as "off-balance sheet financial instruments that permit

one party (beneficiary) to transfer credit risk of areference asset, which it owns, to another party

(guarantor) without actually selling the asset". It,therefore, "unbundles" credit risk from the creditinstrument and trades it separately


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CHARACTERISTICS

Contract between 2 parties-protection buyerand seller

Buyer pays a premium

Reference asset

Credit event

Settlement


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CONVENTIONAL PRODUCTS

Guarantees, Letter of credit,

Insurance, Securitization

Unfunded participation


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DERIVATIVES v/s

CONVENTIONAL PRODUCTS

ADVANTAGES:

Conventional products are less liquid

Banks cannot offer guarantees to other banksand FIs

Securitization involves transaction cost

Insurance Cos and mutual funds prohibitedfrom undertaking direct exposure like lending.


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Vendors and suppliers can hedge credit riskwithout recourse to funding, especially whenlimits used up.

Capital can be used more efficiently.

Spreads will narrow as markets acquiregreater liquidity.


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ISDA Definitions

Protection Seller

refers to the party that contracts to receive premiumsor interest-related payments in return for assuming thecredit risk on an asset or group of assets from theProtection Buyer. The Protection Seller is also known

in the market as the Credit Risk Buyer or Guarantor. Protection Buyer

refers to the party that contracts to transfer the creditrisk on an asset or group of assets to the ProtectionSeller. The Protection Buyer is also known in themarket as the Credit Risk Seller or Beneficiary.

Premium

is the fee the protection buyer pays to the protectionseller as in case of insurance business.


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Credit Event

is defined as a scenario or condition agreedbetween the contracting parties that will trigger

the credit event payment from the ProtectionSeller to the Protection Buyer. Credit eventsusually include bankruptcy, insolvency,merger, failure to pay, repudiation, and

restructuring, delinquency, price decline orrating downgrade of the underlying asset /issuer.


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Reference Asset

refers to the asset to which payments under the creditderivative contract are referenced or linked. It is alsocalled reference obligation.

Underlying Asset refers to the asset on which credit risk protection is

bought by the Protection Buyer. It could be a bankloan, corporate bond / debenture, trade receivable,emerging market debt, municipal debt, etc. It could

also be a portfolio of credit products. This is usuallyalso the Reference Asset.

Reference Entity

is the entity upon whose credit the contract is based.


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Deliverable Obligation

defines what assets are eligible for delivery assettlement in a physical delivery contract. It usuallyincludes Reference Obligation but will often be broader

to include other obligations. Obligations

defines what assets may trigger a Credit Event. Theseare usually same as the underlying asset.

Sponsor denotes the entity that places the portfolio in a Special

Purpose Vehicle for issue of notes.


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SeniorDebt

means that portion of funding in case of structuring of aCollateralized Debt Issue (CDO), which has the lowestrisk weight, or the highest rated debt

Mezzanine Debt refers to that portion of funding in case of structuring of

a Collateralized Debt Issue (CDO), which has debt inascending order of risk weights, or in descending orderof ratings.

Equity refers to the balance funding in case of structuring of a

Collateralized Debt Issue (CDO), which has the highestrisk weight, or the lowest rated debt.


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TYPES OF CREDIT DERIVATIVES

CDS

TRS

CLN

Default Option

CDO


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Credit Default Swap

A buyer (A) pays a premium (single or periodic

payments) to a seller (B) but if a credit event

occurs the seller (B) will compensate thebuyer.

A - buyer B - seller Reference asset

premium

Contingent payment


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EXAMPLE

The protection buyer (A) enters a 1-year credit

default swap on a notional of $100M worth of 10-year

bond issued by XYZ. Annual payment is 50 bp.

At the beginning of the year A pays $500,000 to the

seller.

Assume there is a default of XYZ bond by the end of

the year. Now the bond is traded at 40 cents ondollar.

The protection seller will compensate A by $60M.


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CHARACTERISTICS

Contingent settlement, which is triggered bya Credit Event, can be calculated in severalways. Settlement options include:

physical delivery of Reference Obligation (orother Deliverable Obligations) in exchangefor par value

cash settlement equal to

cash settlement equal to an agreed % ofnotional e.g. 50% of the notional of thetransaction.


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BENEFITS

Effective tool for hedging against changes in CreditSpreads - mark-to-market. ..effective tool for hedgingchanges in credit spread as well as default risk.

Ability to create custom maturity products Management of concentration of credit risk within

credit portfolios

Management of credit limits - For banks that have

loans or transactions with counterparties that requirefurther funding but are constrained because of internalor regulatory credit limits,


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PRICING

T: Life of credit default swap

pi: Risk-neutral default probability density at time t

u(t): Present value of $1 per year on payment datesbetween time zero and time t

e(t) : Present value of an accrual payment at time t

v(t): Present value of $1 received at time t

w : Total payments per year made by CDS buyer

s : Value ofw for which CDS value is zero

T: Risk-neutral probability of no credit eventduring the life of the swap

A(t): Accrued interest on the reference obligation attime tas a percent of face value


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PV of CDS Payments per $1 of

Notional

If default event occurs at t < T, PV ofpayments is

If no default event, PV of payments is

Expected PV is

!

Tn

i

iii Tuwtetupw1

)()]()([

)]()([ tetuw

)(Twu


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PV of CDS Costs per $1 of Notional

Principal

If default event occurs at t < Tcost is

Expected cost is

)(])(1[1

ii

n

i

i tvpRtAR!

RtARRtA )(1])(1[1 !


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Value of CDS to Buyer

Value is expected PV of payments less expectedPV of costs

)(])()([

)(])(1[

1

1

Tutetupw

tvpRtAR

n

i

iii

n

i

iii

T

!

!


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CDS Rate

CDS rate sets value tozero

!

!

T

!n

i

iii

n

i

iii

Tutetup

tvpRtAR

s

1

1

)()]()([

)(])(1[


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Alternative Uses of the Formula

To calculate CDS spreads from theprobabilities of default and expected recoveryrate

To bootstrap the probabilities of default fromCDS spreads and expected recovery rates


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Sensitivity to Recovery Rate

Vanilla CDS is not very sensitive to therecovery rate providing the same recoveryrate is used to estimate default probabilities

and calculate payoffs Binary swaps, which provide a fixed payoff in

the event of a default, are much moresensitive to recovery rates


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First-to-default swaps

Similar to a regular CDS

Several reference entities and referencebonds

First entity to default triggers a payoff

Settlement is same as ordinary CDS


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Valuation

Each reference entity is simulated todetermine when if ever it defaults

Valuation is sensitive to default correlation

A conservative (and easy) assumption for theseller is that all correlations are zero


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Seller Default Risk

The impact of seller default risk on a CDSswap can be calculated by jointly simulatingthe reference entity and the seller


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TOTAL RETURN SWAP

Protection buyer (A) makes a series of payments linked

to the total return on a reference asset. In exchange

the protection seller makes a series of payments tied

to a reference rate (Libor or Treasury plus a spread).


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Total Return Swap (TRS)

A - buyer B - seller

Payment tied to reference asset

Payment tied to reference rate

Reference asset


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Uses of a TRS

Total Return Swaps are usually used afinancing vehicles

Receiver wants to invest in bond

Payer (a financial institution) buys the bondand agrees to the swap

Payer has less credit exposure than if it had

lent Receiver money to buy bond


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Valuation of TRS

If there were no risk of default by receiver, thevalue of a TRS would be difference betweenvalue of reference bond and value of LIBOR

bond The spread above LIBOR would be zero

In practice the payer loses money if thereceiver defaults at a time when the bondvalue has declined


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Example TRS

Bank A made a $100M loan to company XYZ at a fixed rate of 10%.

The bank can hedge the exposure to XYZ by entering TRS with

counterparty B. The bank promises to pay the interest on the loan plus

the change in market value of the loan in exchange for LIBOR + 50 bp.

Assume that LIBOR=9% and by the end of the year the value of the

bond drops from $100 to $95M.

The bank has to pay $10M-$5M=5M and will receive in exchange

$9+$0.5M=9.5M


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Credit Spread Options

These provide a payoff dependent onmovements in a particular credit spread.

There is usually no payoff in the event of a

default on the reference asset Payoff may be defined in terms of difference

between actual spread and a strike spread orin terms of the difference between the price of

an FRN and a strike price


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Valuation

European options can be valued usingBlacks model

This assumes that, conditional on no default,

spread or FRN price is lognormal Need a volatility for forward credit spread or

forward FRN price

Must multiply Blacks formula by risk-neutralprobability of no default


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Collateralized Debt Obligation

A pool of debt issues are put into a specialpurpose trust

Trust issues claims against the debt in a

number of tranches First tranche covers x% of notional and

absorbs first x% of default losses

Second tranche covers y% of notional andabsorbs next y% of default losses


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Collateralized Debt Obligation

Trust

Bond 1

Bond 2

Bond 3

Bond n

Average Yield

8.5%

Tranche 1

1st 5% of loss

Yield = 35%

Tranche 22nd 10% of loss

Yield = 15%

Tranche 3

3

rd

10% of lossYield = 7.5%

Tranche 4

Residual loss

Yield = 6%


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CDOs continued

Note that average yield on tranches equals averageyield on bonds less fee taken by trust manager

Often trust manager holds first tranche

0.05 35% 0.10 15% 0.10 7.5% 0.75 6%

bonds i ii y w y

u

! v v v v


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CDO Applications

Can provide a range of credit quality debtobjects

Can create high quality debt from low quality

debt Can create high yield debt from average risk

debt

Can create artificial short by selling tranchesbefore buying bonds


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Valuing CDO Tranches

Depends on default correlation of bonds inportfolio

Must use Monte Carlo simulation

It is easiest to handle the default correlationwith the Gaussian copula model


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Credit Linked Notes (CLN)

Combine a regular coupon-paying note with

some credit risk feature.

The goal is to increase the yield to the investor

in exchange for taking some credit risk.


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Credit Linked Notes (CLN)

Combine a regular coupon-paying note with

some credit risk feature.

The goal is to increase the yield to the investor

in exchange for taking some credit risk.


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CLN

A buys a CLN, B invests the money in a high-rated investment and makes a short positionin a credit default swap.

The investment yields LIBOR+Ybp, the shortposition allows to increase the yield by Xbp,thus the investor gets LIBOR+Y+X.


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Types of Credit Linked Note

Type Maximal Loss

Asset-backed Initial investment

Compound Credit Amount from the first default

Principal Protection Interest

Enhanced Asset Return Pre-determined


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Credit Linked Note

Credit swap

buyerinvestor

AAA asset

CLN =

AAA note +

Credit swap

par

L+X+Y

Contingent payment

Xbp

Contingent payment

par LIBOR+Y

Asset backed securities can be very dangerous!


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Pricing and Hedging Credit

Derivatives

1. Actuarial approach historic default rates

relies on actual, not risk-neutral probabilities

2. Bond credit spread

3. Equity prices Mertons model


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Actuarial Method

1Y 1% probability of default2Y: 0.01*0.90+0.02*0.07+0.05*0.02=1.14%

Starting Ending state Total

State A B C D

A 0.90 0.07 0.02 0.01 1.00

B 0.05 0.90 0.03 0.02 1.00C 0 0.10 0.85 0.05 1.00

D 0 0 0 1.00 1.00


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If the recovery rate is 60%, the expected costs are

1Y: 1%*(100%-60%) = 0.4%

2Y: 1.14%*(100%-60%) = 0.456%

Annual cost (no discounting):

800,42$%)60%100(2

%14.1%110$ !

M


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Credit Spread Method

Compare the yield of XYZ with the yield of

default-free asset. The annual protection

cost is

Annual Cost = $10M (6.60%-6%) = $60,000


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Equity Price Method

Following the Mertons model the fair value of thePut is

The annual protection fee will be the cost of Putdivided by the number of years.

To hedge the protection seller would go short the

following amount of stocks

)()( 21 dNKedNVPutrT

!

)(

11

1

dNS

V

V

Put!

x

x

x

x

D i ti INDIAN


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Derivatives INDIAN

CONTEXT

June 2000 Equity Indexfutures

June 2001 Equity Indexoptions

July 2001 Stock Options November 2001 Stock futures

June 2003 Interest ratefutures

1980s CurrencyForwards

1997 Long term FC Rupee swaps

July 1999 Interest rateswaps and FRAs

July 2003 FC-Rupeeoptions

Exchange tradedOTC

November 2002 - RBIWorking group on Rupee derivativesMarch 2003 - RBI Working group on credit derivatives


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Regulatory Issues Pertaining to Credit

Derivatives Policies and Procedures for Valuation and Risk Control

Banks / FIs, etc. using credit derivatives should haveadequate systems in place to manage associated risks.

Policy duly approved by the Board of Directors;

Adequate MIS to make senior management aware of therisks being undertaken;

Credit risk acquired through a credit derivative is captured

within banks normal credit approval and monitoring regime;


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Cont

Systems to assess and account for the possibility of defaultcorrelation between reference asset and the protection provider;

Procedure to determine an appropriate liquidity reserve to beheld against uncertainty in valuation. This is important especially

where the reference asset is illiquid like a loan.

Valuation adjustments are recorded to decrease the asset orincrease the liability arising from the initial valuation of a creditderivative transaction by the banks approved mathematical

models.


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Issues Relating to Participants

Banks, Financial Institutions, or NBFCs, Mutual Funds /Insurance companies/ corporates that enter into creditderivatives transactions should be made responsible forensuring that the transactions are appropriate for thecounterparty entering into such transactions.

Banks, Financial Institutions or NBFCs, Mutual Funds /Insurance companies /corporates that enter into creditderivatives transactions should not be permitted to do so withoutobtaining from the counterparty, a copy of a resolution passedby their Board of Directors, authorizing the counterparty to

transact in credit derivatives.


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Banks, Financial Institutions or NBFCs, Mutual Funds /Insurance companies /corporates that enter into creditderivatives transactions should also take necessary steps toensure that the transaction entered into by the counterpartycomplies with other regulations in force.


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Issues Relating to Legal and

Documentation

The market for credit derivatives is highly dependent uponlegal enforceability and thus, requires stringent documentationstandards. Given this, there is a high likelihood that participantsmay wish to draft their own sets of documentation. One methodof ensuring that the market is efficient and is not encumbered by

varying types of documents is to standardize the documentationused by the participants. The International Swaps andDerivatives Association (ISDA) has done extensive work ondocumentation of all derivatives including credit derivatives.Therefore, it would be preferable if transactions be covered bythe 1992 ISDA Master Agreement and the 1999 ISDA Credit

Derivatives Definitions and subsequent supplements to the 1999ISDA Credit Derivatives definitions. The only exception to thisshould be Credit Linked Notes that are typically issued as bondsand are therefore subject to the documentation requirements ofbonds.


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Issues Relating to Exposure Norms

As has been described in the Monetary and Credit PolicyStatement of April 2001, exposure ceilings for all fund basedand non-fund based exposures will be computed in relation tototal capital as defined under capital adequacy standards. Thispractice will naturally be applicable to determining the exposurearising out of credit derivative transactions as well. As regardsthe treatment of non-fund based credit limits, from April 1, 2003exposure calculation will be computed on the basis of 100% ofnon-fund based exposures replacing the current proportion at50%.


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In the case of Credit Derivatives, exposure for a specificcredit derivative will be driven mainly by whether the holder ofthe credit derivative is the protection buyer or the protectionseller. This will make the treatment of credit derivatives forexposure norms somewhat different from other derivatives suchas interest rate swaps and currency swaps.


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While determining the overall sectoral / borrower group /individual company exposure, suitable reduction should begiven in the level of exposure with respect to the creditprotection bought by means of credit derivatives. The protectionbuyer is, however, exposed to the credit risk of protection sellerin case of insolvency.

Conversely, the protection seller's exposure would increase asthe protection seller acquires what is equivalent to a creditexposure on the reference asset. For the credit protection seller,

the method of measuring exposure that would be applicablewould be similar to the manner in which non-fund based creditlimits such as guarantees are reckoned.


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Issues Relating to Capital Adequacy

RequirementsBefore granting capital relief to any form of credit derivative, thesupervisor must be satisfied both that the bank fulfils minimumconditions relating to risk management processes and that thecredit derivative is direct, explicit, irrevocable andunconditional. These conditions are explained below.

Direct

The credit protection must represent a direct claim on theprotection provider.

Explicit

The credit protection must be linked to specific exposures,so that the extent of the cover is clearly defined andincontrovertible.


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Irrevocable

Other than a protection purchasers non-paymentof money due in respect of the credit protection

contract, there must be no clause in the contract thatwould allow the protection provider unilaterally tocancel the credit cover.

Unconditional

There should be no clause in the protectioncontract that could prevent the protection providerfrom being obliged to pay out in a timely manner inthe event that the original obligor fails to make thepayment(s) due.


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Presence of mismatches:

Asset mismatches: Asset mismatch will arise ifthe underlying asset is different from the referenceobligation (in case of cash settlement) or deliverableobligation (in case of physical settlement). It should

be ascertained that there are no asset mismatchesbefore offering complete capital relief to a protectionbuyer from the underlying credit.


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Maturity mismatches: If the maturity of thecredit derivative contract is less than the maturity ofthe underlying asset, then it would construe as amaturity mismatch though the protection buyer would

be completely hedged if the contract maturity were tobe higher than the maturity of the underlying asset. Inthe event of a maturity mismatch, the regulatorycapital to be allocated can be based on either of the

views adopted for the purpose of computation ofcapital adequacy requirements.


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Issues related to Accounting

Normal accounting entries for credit derivative transactionsare fairly straightforward depending on cash flows that takeplace at various points in time during the tenor of thetransaction. e.g. for a credit default swap, there will be periodicpayment of fees by the protection buyer to the protection seller.If there is a credit event, then settlement will be appropriatelyaccounted depending on whether cash settled or settled viaphysical exchange versus par payment.


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The FASB issued FAS 138, Accounting for CertainDerivative Instruments and Certain Hedging Activities An

Amendment of FASB Statement No. 133. These rules establisha market value and hedge accounting framework for derivativesthat goes into effect for fiscal year beginning after June 15,

2002. These standards apply to US multinationals and financialinstitutions as well as all foreign firms who are obliged to followUS GAAP (Generally Accepted Accounting Principles). In arelated development, the International Accounting StandardsCommittee (IASC), a London based organisation approved IAS

39, which sets comprehensive accounting requirements forfinancial instruments for international companies. IAS 39 hasgone in effect since beginning of 2002 for companies that reportunder IAS standards. Though both standards are identical, thereare some minor differences.


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