FAQ’s on Capital market

8/6/2019 FAQs on Capital market

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FAQs on Capital MarketFAQs on Capital MarketCA. P.S. MenonCA. P.S. Menon


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Capital MarketCapital Market

One of the most important segments ofOne of the most important segments ofthe Indian financial systemthe Indian financial system

It is the market available to theIt is the market available to thecompanies for meeting their requirementscompanies for meeting their requirements

of the longof the long--term funds. It refers to all theterm funds. It refers to all thefacilities and the institutionalfacilities and the institutionalarrangements for borrowing and lendingarrangements for borrowing and lendingfunds.funds.

Consists of a number of individuals andConsists of a number of individuals andinstitutions (including the Government)institutions (including the Government)that canalise the supply and demand forthat canalise the supply and demand for

longlong --term capital and claims on it.term capital and claims on it.


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Capital MarketCapital Market

The demandThe demand for long term capitalfor long term capitalcomes predominantly fromcomes predominantly from

private sector manufacturingprivate sector manufacturing

industries, agriculture sector,industries, agriculture sector, trade and the Government agencies.trade and the Government agencies.

The supplyThe supply of funds for the capitalof funds for the capitalmarket comes largely frommarket comes largely from

individual and corporate savings,individual and corporate savings, banks, insurance companies,banks, insurance companies, specialised financing agenciesspecialised financing agencies and the surplus of Governments.and the surplus of Governments.


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Broadly Divided intoBroadly Divided into

1.1. GiltGilt--edged marketedged market

the market for Government and semithe market for Government and semi--governmentgovernmentsecurities, backed by thesecurities, backed by the Reserve Bank of IndiaReserve Bank of India(RBI)(RBI)..

Government securities are tradeable debtGovernment securities are tradeable debtinstruments issued by the Government for meetinginstruments issued by the Government for meetingits financial requirements.its financial requirements.

The term giltThe term gilt--edged means 'ofthe best quality'. Thisedged means 'ofthe best quality'. This

is becauseth

e Government

securities do no

tsufferis because

the Governmen

tsecuri

ties do no

tsufferfrom risk of default and are highly liquid (as theyfrom risk of default and are highly liquid (as they

can be easily sold in the market attheir currentcan be easily sold in the market attheir currentprice).price).

The open market operations ofthe RBI are alsoThe open market operations ofthe RBI are also

conducted in such securities.conducted in such securities.


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SEBISEBI The Securities and Exchange Board of IndiaThe Securities and Exchange Board of India

the regulatory authority established under the SEBI Actthe regulatory authority established under the SEBI Act1992, in order to protect the interests of the investors in1992, in order to protect the interests of the investors insecurities as well as promote the development of thesecurities as well as promote the development of thecapital market.capital market.

Regulating the business in stock exchanges;Regulating the business in stock exchanges; Supervising the working of stock brokers, share transferSupervising the working of stock brokers, share transfer

agents, merchant bankers, underwriters, etc;agents, merchant bankers, underwriters, etc; Prohibiting unfair trade practices in the securitiesProhibiting unfair trade practices in the securities

marketmarket..

Departments of SEBI that take care of the activities in theDepartments of SEBI that take care of the activities in thesecondary market:secondary market:--

Market Intermediaries Registration and SupervisionMarket Intermediaries Registration and SupervisionDepartmentDepartment (MIRSD)(MIRSD) -- concerned withthe registration,concerned withthe registration,supervision, compliance monitoring and inspections of allsupervision, compliance monitoring and inspections of allmarket intermediaries in respect of all segments ofthemarket intermediaries in respect of all segments ofthemarkets, such as equity, equity derivatives, debt and debtmarkets, such as equity, equity derivatives, debt and debtrelated derivatives.related derivatives.


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SEBISEBI Market Regulation Department (MRDMarket Regulation Department (MRD))

-- concerned with formulation of newconcerned with formulation of newpolicies as well as supervising thepolicies as well as supervising thefunctioning and operations (exceptfunctioning and operations (exceptrelating to derivatives) of securitiesrelating to derivatives) of securities

exchanges, their subsidiaries, and marketexchanges, their subsidiaries, and marketinstitutions such as Clearing andinstitutions such as Clearing andsettlement organizations and Depositories.settlement organizations and Depositories.

Derivatives and New ProductsDerivatives and New ProductsDepartmentsDepartments (DNPD)(DNPD) -- concerned withconcerned withsupervising trading at derivativessupervising trading at derivativessegments of stock exchanges, introducingsegments of stock exchanges, introducingnew products to be traded and consequentnew products to be traded and consequent

policy changes.policy c

hanges.


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FAQsFAQs1.1. What is the process of bookWhat is the process of book building?building? Book Building is basically a capital issuance processBook Building is basically a capital issuance process

used in Initial Public Offer (IPO) which aids price andused in Initial Public Offer (IPO) which aids price anddemand discovery.demand discovery.

Used for marketing a public offer of equi

ty s

hares of aUsed for marke

ting a public offer of equi

ty s

hares of acompany.company.

MechanismMechanism -- during the period for whichthe book forduring the period for whichthe book forthe IPO is open,the IPO is open,

bids are collected from investors at various prices, which arebids are collected from investors at various prices, which are

above or equalto

the floor price.above or equal

to

the floor price.

Aims attapping both wholesale and retail investors.Aims attapping both wholesale and retail investors.

The offer/issue price is then determined after the bid closingThe offer/issue price is then determined after the bid closingdate based on certain evaluation criteria.date based on certain evaluation criteria.


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The ProcessThe Process The Issuer who is planning an IPO nominates aThe Issuer who is planning an IPO nominates alead merchant banker as alead merchant banker as a 'book runner'.'book runner'. The Issuer specifies the number of securities to beThe Issuer specifies the number of securities to be

issued and theissued and the price bandprice band for orders.for orders. The Issuer also appointsThe Issuer also appoints syndicate memberssyndicate members withwith

whom orders can be placed by the investors.whom orders can be placed by the investors. Investors place their order with a syndicateInvestors place their order with a syndicate

member who inputs the orders into themember who inputs the orders into the 'electronic'electronicbook'.book'. This process is called 'bidding' and is similarThis process is called 'bidding' and is similarto open auction.to open auction.

A Book should remain open for a minimum ofA Book should remain open for a minimum of55days.days.

Bids cannot be entered less than the floor price.Bids cannot be entered less than the floor price. Bids can be revised by the bidder before the issueBids can be revised by the bidder before the issue

closescloses


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On the close ofthe book building period theOn the close ofthe book building period thebook runner evaluates the bids on the basis ofbook runner evaluates the bids on the basis ofthe evaluation criteria which may includethe evaluation criteria which may include --

Price AggressionPrice Aggression Investor qualityInvestor quality Earliness of bids, etc.Earliness of bids, etc.

The book runner and the companyThe book runner and the company conclude theconclude the

final pricefinal price at which it is willing to issue theat which it is willing to issue thestock and allocation of securities.stock and allocation of securities. Generally, the number of shares are fixed,Generally, the number of shares are fixed, thethe

issue size gets frozenissue size gets frozen based on the price perbased on the price pershare discovered throughthe book buildingshare discovered throughthe book building

process.process. Allocation of securitiesAllocation of securities is made to theis made to the

successful bidders.successful bidders. Book Building is a good concept and representsBook Building is a good concept and represents

a capital market which is in the process ofa capital market which is in the process ofmaturin .maturin .


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Difference between bookDifference between book

building and normal public issuebuilding and normal public issueFeatureFeaturess

Fixed Price processFixed Price process Book BuildingBook Buildingprocessprocess

PricingPricing Price is known inPrice is known inadvance to theadvance to the

investor.investor.

Not known. Only anNot known. Only anindicative price range isindicative price range is

known.known.

DemandDemand Demand is knownDemand is knownonly after the closureonly after the closureofthe issueofthe issue

Can be known everydayCan be known everydayas the book is builtas the book is built

PaymentPayment PaymentPayment --atthe timeatthe timeof subscription.of subscription.refund given afterrefund given after

allocation.allocation.

Payment only afterPayment only afterallocation.allocation.


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2. Why do companies proposing an IPO post2. Why do companies proposing an IPO postat a lower price when a lot of labour hasat a lower price when a lot of labour hasgot into fixing the price band and valuinggot into fixing the price band and valuingthe share price of the company?the share price of the company?

a)a) Sometimes the market conditions may beSometimes the market conditions may bebad due to poor sentiment.bad due to poor sentiment.

b)b) Negative developments may have taken placeNegative developments may have taken placeafter the IPO documents have been approvedafter the IPO documents have been approvedand the news has been made public.and the news has been made public.--DLFDLF

c)c) There is poor perception ofthe Management ,There is poor perception ofthe Management ,Industry in whichthe company operates.Industry in whichthe company operates.

d)d) Due to competition between MerchantDue to competition between MerchantBankers an unrealistic price has been set forBankers an unrealistic price has been set forthe IPO.the IPO.

e)e) Grey market operations cause undueGrey market operations cause unduefluctuations in the stock exchanges on listing.fluctuations in the stock exchanges on listing.


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3. What do we mean by Green Shoe3. What do we mean by Green ShoeOption?Option?

Ans. An option for allocating Equity SharesAns. An option for allocating Equity Sharesin excess ofthe Equity Shares includedin excess ofthe Equity Shares includedin thein the

Issue in consultation withthe BRLMs, inIssue in consultation withthe BRLMs, inorder to operate a post listing priceorder to operate a post listing pricestabilising mechanism, in accordancestabilising mechanism, in accordance

with

th

e SEBI Guidelineswi

th

the S

EBI Guidelines

The Green Shoe CompanyThe Green Shoe Company was the firstwas the firstissuer to allow the overissuer to allow the over--allotment optionallotment optionto its underwriters, hence the name.to its underwriters, hence the name.


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PresumptionsPresumptions Pricing is reasonable & conservative ,Pricing is reasonable & conservative ,

possibility to go up rather than down.possibility to go up rather than down.

If pricing comes down morale will be lost.If pricing comes down morale will be lost.

Usually 15 % of subscribers areUsually 15 % of subscribers arespeculative i.e. stags.speculative i.e. stags.

If price goes down within 30 days of listingIf price goes down within 30 days of listingit may create artificial panic causingit may create artificial panic causing

remaining 85% allottees to sell.remaining 85% allottees to sell. Hence buying is done through a StablisingHence buying is done through a Stablising

agentto stablise the price post listing.agentto stablise the price post listing.


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ProcessProcess

It is always BuyIt is always Buy not sell.not sell.

Applied when price falls below issueApplied when price falls below issue

price.price. Always makes a profit.Always makes a profit.

Valid for 30 days.Valid for 30 days.

(Profit(Profit--Expenses) goes to InvestorExpenses) goes to InvestorProtection fund of Stock Exchange.Protection fund of Stock Exchange.

How much?, When?, at What priceHow much?, When?, at What price

etc

the S

tablising Agen

twill decide.e

tc

the S

tablising Agen

twill decide.


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SituationsSituations

15% shares purchased within 30days15% shares purchased within 30days pricepricestabilises.stabilises.-- SA will hand over shares toSA will hand over shares topromoterspromoters-- profits to IPF of Stock Exch.profits to IPF of Stock Exch.

Price does not stablisePrice does not stablise operation called off.operation called off.

Price fall is justified.Price fall is jus

tified.

SA holds cash after 30 days.SA holds cash after 30 days.--Co. given cash andCo. given cash andover allottment is made.over allottment is made.

5% purchased5% purchased --10% cash given & over10% cash given & overallottment made and total 15% shares handedallottment made and total 15% shares handedover to promoters.over to promoters.

LockLock--in period of promoters not affected.in period of promoters not affected. 20% post issue not disturbed since it is reckoned20% post issue not disturbed since it is reckoned

immediately on allottment. Subsequent overimmediately on allottment. Subsequent overallottment will not affecttheir contribution.allottment will not affecttheir contribution.


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ICICI Bank had raised Rs 1,294 croreICICI Bank had raised Rs 1,294 croreth

rough

its green

throug

hits green--s

hoe op

tion in

the locals

hoe op

tion in

the localmarket in Aug 2007. The bank had raisedmarket in Aug 2007. The bank had raised

Rs 8,750 crore through its local issue andRs 8,750 crore through its local issue andan equal amountthrough its overseasan equal amountthrough its overseasissuance, too.issuance, too.

However, the bank has used only aroundHowever, the bank has used only aroundRs 18.5 crore for stabilising its shares. TheRs 18.5 crore for stabilising its shares. Thebank had earlier priced its local issue at Rsbank had earlier priced its local issue at Rs94

0. However, for retail s

hare

holders,

the

940. However, for re

tail s

hare

holders,

thebank had given a discount of Rs 50 perbank had given a discount of Rs 50 per

share.share.

The share price ofthe bank fell muchThe share price ofthe bank fell much

below the issue price later on.below the issue price later on.


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Secondary Market FAQsSecondary Market FAQs1.1. What is Trade for Trade in NSEWhat is Trade for Trade in NSE?? Trading in this segment is available only for the securitiesTrading in this segment is available only for the securities Whichhave not established connectivity with boththeWhichhave not established connectivity with boththe

depositories as per SEBI directive. The list ofthese securities isdepositories as per SEBI directive. The list ofthese securities isnotified by SEBI from time to time.notified by SEBI from time to time.

On account of surveillance actionOn account of surveillance action

Trade for Trade means that every transaction is settled forTrade for Trade means that every transaction is settled forDelivery without netting .Delivery without netting . For eg. If a person buys 100 shares of Reliance and sells 100 ofFor eg. If a person buys 100 shares of Reliance and sells 100 of

the same during the day , under normal segmentthe twothe same during the day , under normal segmentthe twotransactions are netted and only the difference in money termstransactions are netted and only the difference in money termshas to be paid / received. However ifthe same share is shiftedhas to be paid / received. However ifthe same share is shiftedto Trade for Trade segment , the purchase of 100 shares has toto Trade for Trade segment , the purchase of 100 shares has to

paid for and delivery taken while for the sale of 100 shares ,paid for and delivery taken while for the sale of 100 shares ,delivery has to be given and payout collected separately. Thisdelivery has to be given and payout collected separately. Thisensures that a lot of speculative activity is taken outthe shareensures that a lot of speculative activity is taken outthe shareon shifting to Trade for Trade segment.on shifting to Trade for Trade segment.


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2. How closing price of share is valued2. How closing price of share is valuedin stock exchange?in stock exchange?

Ans .Computation of closing price ofAns .Computation of closing price ofscrips in the Cash Segment:scrips in the Cash Segment:

The closing price of scrips is computedThe closing price of scrips is computed

byth

eExc

hange on

the basis ofby

the

Exc

hange on

the basis ofweighted average price of all tradesweighted average price of all trades

executed during the last 30 minutes ofexecuted during the last 30 minutes ofthe continuous trading session.the continuous trading session.

However, ifthere is no trade recordedHowever, ifthere is no trade recordedduring the last 30 minutes, then the lastduring the last 30 minutes, then the lasttraded price of a scrip in the continuoustraded price of a scrip in the continuoustrading session is taken as the officialtrading session is taken as the official

closing price.closing price.


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3. What do you mean by Upper3. What do you mean by Upper

circuits and Lower Circuits ?circuits and Lower Circuits ? The Exchange has implemented indexThe Exchange has implemented index--based marketbased market--widewide

circuit breakers in compulsory rolling settlement with effectcircuit breakers in compulsory rolling settlement with effectfrom July 02, 2001. In addition to the circuit breakers, pricefrom July 02, 2001. In addition to the circuit breakers, pricebands are also applicable on individual securitiesbands are also applicable on individual securities

IndexIndex--based Marketbased Market--wide Circuit Breakerswide Circuit Breakers

The indexThe index--based marketbased market--wide circuit breaker systemwide circuit breaker systemapplies at 3 stages ofthe index movement, either way viz.applies at 3 stages ofthe index movement, either way viz.at 10%, 15% and 20%. These circuit breakers whenat 10%, 15% and 20%. These circuit breakers whentriggered, bring about a coordinated trading halt in alltriggered, bring about a coordinated trading halt in all

equit

y and equit

y derivat

ive market

s nat

ionwide.Th

eequit

y and equit

y derivat

ive market

s nat

ionwide.Th

emarketmarket--wide circuit breakers are triggered by movement ofwide circuit breakers are triggered by movement ofeither the BSE Sensex or the NSE S&P CNX Nifty, whichevereither the BSE Sensex or the NSE S&P CNX Nifty, whicheveris breached earlier.is breached earlier.


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Daily price bands that are applicable on securitiesDaily price bands that are applicable on securities

Daily price bands of2% (either way) onDaily price bands of2% (either way) onspecified securitiesspecified securities

Daily price bands of 5% (either way) onDaily price bands of 5% (either way) onspecified securitiesspecified securities

Daily price bands of 10% (either way) onDaily price bands of 10% (either way) onspecified securitiesspecified securities No price bands are applicable on:No price bands are applicable on:

Scrips on which derivative products areScrips on which derivative products areavailable oravailable or

Scrips included in indices on which derivativeScrips included in indices on which derivativeproducts are available. (In order to preventproducts are available. (In order to preventmembers from entering orders at nonmembers from entering orders at non--genuinegenuineprices in such securities, the Exchange hasprices in such securities, the Exchange hasfixed operating range of20% for suchfixed operating range of20% for suchsecurities)securities)


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Price bands of20% (either way) on allPrice bands of20% (either way) on all

remaining scrips (including debentures,remaining scrips (including deben

tures,warrants, preference shares etc).warrants, preference shares etc).

The price bands for the securities in theThe price bands for the securities in theLimited Physical Market are the same asLimited Physical Market are the same as

those applicable for the securities in thethose applicable for the securities in theNormal Market.Normal Market.

For Auction marketthe price bands ofFor Auction marketthe price bands of20% are applicable.20% are applicable.


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5. What is the criteria for selection of companies for5. What is the criteria for selection of companies for

determining the Index/ Niftydetermining the Index/ Nifty

Ans.Ans. A. Quantitative Criteria:A. Quantitative Criteria:

1.1. Market CapitalizationMarket Capitalization::The scrip be in the top 100 companies listed by marketThe scrip be in the top 100 companies listed by marketcapitalization.capitalization.

Mkt. cap of each scrip should be more than 0.5 % ofthe totalMkt. cap of each scrip should be more than 0.5 % ofthe total

market

capitaliza

tion of

the Index i.e.

the minimum weig

htmarke

tcapi

taliza

tion of

the Index i.e.

the minimum weig

htshould be 0.5 %. Since the SENSEX is a market capitalizationshould be 0.5 %. Since the SENSEX is a market capitalization

weighted index, this is one ofthe primary criteria for scripweighted index, this is one ofthe primary criteria for scripselection. (Market Capitalization would be averaged for last sixselection. (Market Capitalization would be averaged for last sixmonths)months)

2.2. Liquidity:Liquidity:

(i)Trading Frequency:

The scrip s

hould

have been

traded on(i)

Trading Frequency:

The scrip s

hould

have been

traded oneach and every trading day for the last one year. Exceptions caneach and every trading day for the last one year. Exceptions can

be made for extreme reasons like scrip suspension etc.be made for extreme reasons like scrip suspension etc.


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(ii) Number ofTrades: Number ofTrades: The scrip(ii) Number ofTrades: Number ofTrades: The scripshould be among the top 150 companies listed byshould be among the top 150 companies listed byaverage number oftrades per day for the last one year.average number oftrades per day for the last one year.

(iii) Value of Shares Traded: Value of Shares Traded:(iii) Value of Shares Traded: Value of Shares Traded:The scrip should be among the top 150 companies listedThe scrip should be among the top 150 companies listedby average value of shares traded per day for the lastby average value of shares traded per day for the lastone year.one year.

3.3. Continuity:Continuity:Whenever the composition ofthe index is changed, theWhenever the composition ofthe index is changed, the

continuity ofhistorical series of index values is recontinuity ofhistorical series of index values is re--established by correlating the value ofthe revised indexestablished by correlating the value ofthe revised indexto the old index (index before revision). The backto the old index (index before revision). The backcalculation over the last onecalculation over the last one--year period is carried outyear period is carried outand correlation ofthe revised index to the old indexand correlation ofthe revised index to the old indexshould not be less than 0.98. This ensures thattheshould not be less than 0.98. This ensures thatthehistorical continuity ofthe index is maintainedhistorical continuity ofthe index is maintained..


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4.4. Industry RepresentationIndustry Representation::Scrip selection would take into account aScrip selection would take into account abalanced representation ofthe listed companiesbalanced representation ofthe listed companiesin the universe of BSE. The index companiesin the universe of BSE. The index companiesshould be leaders in their industry group.should be leaders in their industry group.

5.5. Listed HistoryListed History::The scrip should have a listing history of atThe scrip should have a listing history of atleast one year on BSE.least one year on BSE.

B.B. Qualitative Criteria:Qualitative Criteria:

Track RecordTrack Record::In the opinion ofthe Index Committee, theIn the opinion ofthe Index Committee, thecompany should have an acceptable trackcompany should have an acceptable trackrecord.record.


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6. How does an Index open at the6. How does an Index open at thehigher or lower level, when thehigher or lower level, when the

markets remain closed?markets remain closed? Ans. The index opening is based on theAns. The index opening is based on the

orders &transaction that are executedorders &transaction that are executed

atthe time of opening .oftrading. Iftheatthe time of opening .oftrading. Iftheinitial trades are athigher prices thaninitial trades are athigher prices thanthe previous days closing prices, thethe previous days closing prices, theIndex will be calculated accordingly andIndex will be calculated accordingly andthe Index will seem to have opened upthe Index will seem to have opened upand vice versa.and vice versa.


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7. What do we mean by Private Equity Firms ? How is7. What do we mean by Private Equity Firms ? How is

Private Equity Firm different from FII and QIBs ? Private Equity Firm different from FII and QIBs ?

Ans.Ans. P.E. FirmsP.E. Firms areare Investment firmsInvestment firms that pool moneythat pool moneyfrom wealthy investors, pension plans and otherfrom wealthy investors, pension plans and otherinstitutional investors to buy or take a stake ininstitutional investors to buy or take a stake incompanies. These firms attemptto find ways to runcompanies. These firms attemptto find ways to runcompanies better and sell them later for a profit. Privatecompanies better and sell them later for a profit. Privateequity firms will often borrow additional money fromequity firms will often borrow additional money frombanks so they can buy companies and only use a smallbanks so they can buy companies and only use a smallportion oftheir own cash. The firms were commonlyportion oftheir own cash. The firms were commonlycalled leveraged buyout firms in the 1980s.called leveraged buyout firms in the 1980s.

Foreign Institutional InvestorForeign Institutional Investor (FII)(FII) is anis an investorinvestor --mostly ofthe form of an institution or entity, whichmostly ofthe form of an institution or entity, whichinvests money in the financial markets of a countryinvests money in the financial markets of a country

differentfrom

the one w

here in

the ins

titu

tion or en

titydifferen

tfrom

the one w

here in

the ins

titu

tion or en

titywas originally incorporated.was originally incorporated.

FII investment is also referred to asFII investment is also referred to as hot moneyhot money.. SEBI has prescribed norms to register FIIs and also toSEBI has prescribed norms to register FIIs and also to

regulate such investments flowing in through FIIs. FEMAregulate such investments flowing in through FIIs. FEMAnorms includes maintenance ofhighly ratednorms includes maintenance ofhighly ratedbonds(collateral) with security exchange.bonds(collateral) with security exchange.


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QIB Qualified Institutional BuyersQIB Qualified Institutional Buyers Qualified Institutional Buyers are those institutionalQualified Institutional Buyers are those institutional

investors who are generally perceived to possess expertiseinvestors who are generally perceived to possess expertiseand the financial muscle to evaluate and invest in theand the financial muscle to evaluate and invest in thecapital markets. In terms of clause 2.2.2B (v) of DIPcapital markets. In terms of clause 2.2.2B (v) of DIPGuidelines, a Qualified Institutional Buyer shall mean:Guidelines, a Qualified Institutional Buyer shall mean:

a. Public financial institution as defined in section 4A ofa. Public financial institution as defined in section 4A oftheCompanies Act, 1956;theCompanies Act, 1956;

b. Scheduled commercial banks;b. Scheduled commercial banks; c. Mutual funds;c. Mutual funds; d. Foreign institutional investor registered with SEBI;d. Foreign institutional investor registered with SEBI; e. Multilateral and bilateral development financiale. Multilateral and bilateral development financial

institutions;institutions; f. Venture capital funds registered with SEBI.f. Venture capital funds registered with SEBI. g. Foreign Venture capital investors registered with SEBI.g. Foreign Venture capital investors registered with SEBI. h. State Industrial Development Corporations.h. State Industrial Development Corporations. i. Insurance Companies registered withthe Insurancei. Insurance Companies registered withthe Insurance

Regulatory and Development Authority (IRDA).Regulatory and Development Authority (IRDA). j. Provident Funds with minimum corpus of Rs.25 croresj. Provident Funds with minimum corpus of Rs.25 crores k. Pension Funds with minimum corpus of Rs. 25 croresk. Pension Funds with minimum corpus of Rs. 25 crores


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What are Credit default swapsWhat are Credit default swaps

CDS are insurance contracts used toCDS are insurance contracts used toprotect debtholders, in particular Mortgageprotect debtholders, in particular MortgageBacked Security (MBS) investors, from theBacked Security (MBS) investors, from therisk of default. As the net worth of banksrisk of default. As the net worth of banks

and other financial institutionsand other financial institutionsdeteriorated because of losses related todeteriorated because of losses related tosubprime mortgages, the likelihoodsubprime mortgages, the likelihoodincreased thatthose providing theincreased thatthose providing theinsurance would have to pay theirinsurance would have to pay their

counterparties. This created uncertaintycounterparties. This created uncertaintyacross the system, as investors wonderedacross the system, as investors wonderedwhich companies would be required to paywhich companies would be required to payto cover mortgage defaults.to cover mortgage defaults.


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Heavy Outstandings.Heavy Outstandings.

The volume of CDS outstanding increased 100The volume of CDS outstanding increased 100--fold from 1998 to 2008, with estimates ofthefold from 1998 to 2008, with estimates ofthedebt covered by CDS contracts, as of Novemberdebt covered by CDS contracts, as of November2008, ranging from US$33 to $47 trillion. CDS2008, ranging from US$33 to $47 trillion. CDS

are lightly regulated. As of2008, there was noare lightly regulated. As of2008, there was nocentral clearinghouse to honor CDS in the event acentral clearinghouse to honor CDS in the event aparty to a CDS proved unable to perform hisparty to a CDS proved unable to perform hisobligations under the CDS contract.obligations under the CDS contract.

Merrill Lynch's large losses in 2008 wereMerrill Lynch's large losses in 2008 were

attributed in partto the drop in value of itsattributed in partto the drop in value of itsunhedged portfolio of collateralized debtunhedged portfolio of collateralized debtobligations (CDOs) after AIG ceased offering CDSobligations (CDOs) after AIG ceased offering CDSon Merrill's CDOs.on Merrill's CDOs.


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Credit Events Bankruptcy Credit event upon merger

Downgrade

Failure to pay

Reference entity fails to make one or more requiredpayments when due

Restructuring etc. Occurs when the terms of theobligation are altered so as to make the new termsless attractive to the debt holder than the originalterms. Eg. Reduction in the interest rate, reduction inthe principal, rescheduling of the principal repaymentschedule


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Illustration of a Credit Default Swap

Reference Obligation: Specific bond issue ofFord Motor Credit Company

Tenor of Swap: 5 years

Swap Premium (payment made by the

protection buyer to the protection seller): 410bps

Notional Amount: $10 million

If a credit event occurs, the protection seller

pays the protection buyer the notionalamount

Contract calls for quarterly payment of theswap premium


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Quarterly Payment ofSwap PremiumQuarterly Payment ofSwap Premium

Number of days in the quarter 92 daysNumber of days in the quarter 92 days

Swap Premium 410 basis pointsSwap Premium 410 basis points

Notional Amount $10 millionNotional Amount $10 million

Quarterly Swap Premium Payment =Quarterly Swap Premium Payment =Notional amount * swap premium (inNotional amount * swap premium (indecimal form) * (number of days indecimal form) * (number of days in

quarter / 360)quar

ter / 360)

= $10,000,000 * 0.0410 * (92 / 360)= $10,000,000 * 0.0410 * (92 / 360)

= $104,777.80= $104,777.80


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Summary In the absence of a credit event occurring in

any quarter, the protection buyer will continueto make a quarterly swap premium payment

If a credit event occurs, the protection sellerpays the protection buyer the notional amount($10 million)

Protection seller receives from the protectionbuyer the Ford Motor Credit Company bonds(i.e. the reference obligation)


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Date post:	07-Apr-2018
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