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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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