krishna cds
TRANSCRIPT
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Credit Default Swapsy ACredit Default Swap (CDS) is similar to an insurance
contract, providing the buyerwith protection against
specific risks associatedw
ith defaults, bankruptcy orcredit rating downgrades.
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Characteristicsy CDS is the mostwidely traded credit derivative
product. Typical term of CDS contract is 5 years (up to10-year CDS).
y CDS documentation is governed by the InternationalSwaps and DerivativesAssociation (ISDA), whichprovides standardized definitions of credit default
swap terms, including definitions ofwhat constitutes acredit event.
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Mechanismy One party sells risk and the counterparty buys that risk.
y The seller of credit risk - who also tends to own the
underlying credit asset - pays a periodic fee to the riskbuyer.
y In return, the risk buyer agrees to pay the seller a setamount if there is a default.
y Buyer pays a premium to seller so that in case of a negativecredit event, the seller takes on the credit risk.
y If no credit default, seller pockets the premium andeveryone is happy.
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ExampleSuppose Bank Abuys a bond which issued by a Steel
Company.
To hedge the default ofSteel Company:
Bank Abuys a credit default swap from Insurance
Company C.
Bank Apays a fixed periodic payments to C, inexchange for default protection.
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Exhibit
Credit Default Swap
BankABuyerInsurance Company CSeller
Steel companyReferenceAsset
Contingent Payment On
Credit Event
Premium Fee
Credit Risk
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Potential Benefitsy CDS help to shift risks from those who hold highly
concentrated portfolios
y CDS potentially reduce borrowing costs and increasescredit supply for corporate and sovereign debtors
y Use of capital more efficiently as players having excesscapital can take up credit risks
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Potential Benefitsy CDS help complete markets, as they provide an
effective means to hedge and trade credit risk.
y CDS allowfinancial institutions to better manage theirexposures, and investors benefit from an enhancedinvestment universe.
y CDS spreads provide a market-based assessment ofcredit conditions.
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Negative Externalitiesy CDS carelessly transacted can result in a concentration
of risk across a fewsystemically important entities
yDefault by counterpartyAcan have a significantimpact on the solvency of counterparty B
y Availability of CDS has enhanced the risk appetite offinancial institutions resulting in excessive risk-taking
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Negative Externalitiesy CDS coupledwith securitization has increased
instances of moral hazard
yIn recession, the likelihood of defaults increases andthe expected payoff on credit default swaps can risequickly.
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Credit Derivatives
Initiatives in Indiay AWorking Group on introduction of credit derivatives
in India was constituted in 2003 with membership
from banks, insurance companies and relateddepartments in the Reserve Bank.
y Conceptual issues, examined the scope for allowingbanks and financial institutions in India to use CDs
y
Draft guidelines on introduction of credit derivativeswere brought out on March 26, 2003 but the issuanceof final guidelineswas postponed.
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Credit Derivatives
Initiatives in Indiay Credit derivativeswould be introduced in a calibrated
manner
yTo begin with, it was decided to permit commercialbanks and primary dealers (PDs) to deal in single-entity Credit Default Swaps (CDS)
y October 24, 2007 for a second round of consultation-
global financial crisis and introduction of CDSwaspostponed
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Credit Derivatives
Initiatives in Indiay The Second Quarter Reviewof Monetary Policy of
2009-10 has proposed introduction of plain vanillaO
TC single-name CDS
for corporate bonds for residententities
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Eligible Participantsy Market-makers (entities permitted to both buy and sell
protection)
y Users (entities not permitted to sell protection butpermitted only to hedge the underlying risk by buyingCDS)
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Market-makersy Market-makers (both protection sellers and buyers,
subject to fulfilment of regulatory stipulations) -
permitted to hold short CDS positions
y a) Commercial Banks, b) Primary Dealers, c) NBFCshaving sound financials and good track record in
providing credit facilities to borrowers, d) InsuranceCompanies and e) Mutual Funds.
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Usersy Users (only protection buyer to hedge underlying
exposure) - not permitted to hold short CDS
positions / sell CDSy Commercial Banks, Primary Dealers, NBFCs, Mutual
Funds, Insurance Companies, Housing FinanceCompanies, Provident Funds, listed Corporates, and
any other institution permitted by the Reserve Bank.yAll CDS trades shall have an RBI regulated entity
at least on one side of the transaction.
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Case study on AIG
y Adversely impacting on counterparty risk.
y AIG had sold CDS referenced to a huge variety ofdifferent assets
y US subprime crisis unfolded
y Incurred more liabilities to fulfil collateral claims
y At one point, the collateral calls on CDS exceededAIGs ability to pay
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