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UNIVERSITY OF MUMBAI
K J SOMAIYA INSTITUTE OF MANAGEMENT STUDIES & RESEARCH
VIDYANAGAR, VIDYAVIHAR (E), MUMBAI 400 077
Project Report on
Submitted By
DEWANG DOSHI
ROLL NO. 08
UNIVERSITY OF MUMBAI
K J SOMAIYA INSTITUTE OF MANAGEMENT STUDIES & RESEARCH
VIDYANAGAR, VIDYAVIHAR (E), MUMBAI 400 077
ACKNOWLEDGEMENT
I owe my deepest gratitude to all the people who helped and supported me during the course of
this project.
My deepest thanks to Prof. Aparna Bhat, the faculty guide of the project, for guiding and
correcting various documents of mine with attention and care. She has provided all the necessary
guidance & valuable inputs which were required for successful completion of the project.
I would also thank my institution K J Somaiya Institute of Management Studies & Research
and my faculty members without whom this project would have been a distant reality.
I also extend my heartfelt thanks to my family members and well-wishers.
DECLARATION
Date:
Place: Mumbai
Dewang Doshi
CERTIFICATE
I, Prof. Aparna Bhat, hereby certify that Mr. Dewang Doshi studying in the 2 nd year of Master of
Management Studies, batch 2011-2013 at K J Somaiya Institute of Management Studies &
Research (SIMSR), has completed the project on Understanding Credit Default Swaps:
Valuations & Regulatory Environment under my guidance as per the norms as prescribed by the
University of Mumbai in the academic year 2012-2013.
Date:
Place: Mumbai
Prof. Aparna Bhat
TABLE OF CONTENTS
Introduction................................................................................................................ 1
Introduction to Credit Derivatives...........................................................................1
Introduction to Credit Default Swaps (CDS).............................................................2
Important Terminologies for CDS.............................................................................2
Credit Default Swaps: Market at Glance.....................................................................4
Evolution of CDS market......................................................................................... 4
Major players in the CDS market.............................................................................6
Various forms of CDSs............................................................................................. 7
Global Credit Derivatives Product Usage.................................................................9
Mechanics of CDS Contract...................................................................................... 10
Example: Simple CDS contract...........................................................................11
CDS Guidelines for India........................................................................................... 13
Objective of RBI:.................................................................................................... 13
Evolution of CDS market in India...........................................................................13
Guidelines by RBI: Overview.................................................................................14
Eligibility norms for market-makers...................................................................15
Settlement methodologies.................................................................................15
Pricing/Valuation methodologies for CDS...........................................................16
Pricing/ Valuation Methodology of FIMMDA............................................................16
Policy document on Valuation of CDS positions (FIMMDA).................................17
Process followed by FIMMDA for valuation curves:.............................................18
Procedure for calculation of CDS-Bond Basis......................................................19
Valuation of CDS contracts:...................................................................................... 22
Historical Default Probabilities:.............................................................................22
Recovery Rates...................................................................................................... 22
Estimating Default Probabilities from Bond Prices.................................................23
Illustration of CDS valuation.................................................................................. 24
Risks associated with CDS........................................................................................ 27
CDS in Indian Markets: The way forward..................................................................28
Introduction
Introduction to Credit Derivatives
The growth in derivatives market in the latter part of the 1990s happened along following of the
three dimensions:
A. New products are emerging as the traditional building blocks forwards and options
have spawned second and third generation derivatives that span complex hybrid,
contingent, and path-dependent risks.
B. New applications are expanding derivatives use beyond the specific management of price
and event risk to the strategic management of portfolio risk, balance sheet growth,
shareholder value, and overall business performance.
C. Derivatives are being extended beyond mainstream interest rate, currency, commodity,
and equity markets to new underlying risks including catastrophe, electricity, inflation,
and credit. Here, we see that credit derivatives fit into this three-dimensional scheme.
The derivatives users relied on purchasing insurance, letters of credit (LC), or negotiating
collateralized mark-to-market credit enhancement provisions in the Master Agreements. So,
corporate entities either carried open exposures to key customers accounts receivable or
purchased insurance, where available, from the factors. Yet these strategies were inefficient,
largely as they do not separate the credit risk management from the asset with which that risk is
associated.
For example, consider a corporate bond, represents a bundle of risks including duration,
convexity, callability, and credit risk (constituting both, risk of default and the risk of volatility in
spreads). So there is clear inefficiency if the only way to adjust credit risk is to buy or sell that
bond, and consequently affect positioning across the entire bundle of risks. Fixed income
derivatives introduced the ability to manage duration, convexity, and callability independently of
bond positions; credit derivatives complete the process by allowing the independent management
of default or credit spread risk.
The credit derivatives are formally, bilateral financial contracts that isolate specific aspects of
credit risk from an underlying instrument and transfer that risk between two parties. Here, a
1
bilateral financial contract is in which the Protection Buyer pays a periodic fee in return for a
Contingent Payment by the Protection Seller following a Credit Event. In so doing, credit
derivatives separate the ownership and management of credit risk from other qualitative and
quantitative aspects of ownership of financial assets. Thus, credit derivatives share one of the key
features of historically successful derivatives products, which is the potential to achieve
efficiency gains through a process of market completion.
They also provide an objective market-pricing benchmark representing the true opportunity cost
of a transaction. They continue to enjoy major growth in the financial markets, aided and abetted
by sophisticated product development and the expansion of product applications beyond price
management to the strategic management of portfolio risk.
Reference Entity: The entity (corporation or sovereign) whose credit risk is transferred
Notional Amount: Dollar (or other currency) amount of credit protection traded, e.g. $10mn
2
Premium (spread): Compensation paid by the protection buyer to the protection seller.
Generally paid quarterly, but expressed as an annualized percent of the Notional
Credit Events: Eventualities suffered by the Reference Entity that "trigger" the contract
Settlement: Once the contract is triggered, the process by which the protection seller
compensates the protection buyer for the loss caused by a Credit Event
A Credit Event is most commonly defined as the occurrence of one or more of the following:
i.
Failure to meet payment obligations when due (after giving effect to the Grace
Period, if any, and only if the failure to pay is above the payment requirement
specified at inception), e.g. Argentina
ii.
iii.
Repudiation ,
iv.
v.
The credit default swaps were first introduced by the mid 1990s. The banks in the early 1980s,
were laying-off parts of their credit risk by means of securitization and later through derivatives.
During the 1990s, strong competitive pressures and rising insolvency numbers, including Enron
and Worldcom, forced banks to manage their credit portfolios more actively. In addition,
regulatory changes such as the introduction of the more risk-sensitive Basel II framework
spurred the development of tools for a more active management of risk and capital. So, CDSs
offered various extensions to existing risk management tools.
CDSs allowed credit risk to be hedged separately from interest rate risk. Unlike securitization,
CDSs requires no prefunding on the part of the protection seller. In the early days, CDSs were
used primarily for hedging purposes. But soon trading in the newly established instruments also
became important and as the market matured, banks, hedge funds and asset managers
increasingly used CDSs to take positions in default risk, thereby providing additional impetus to
market growth.
More recently in 2007 crisis, CDS were tested by the collapse of important market participants
and the failure of relevant reference entities. Following the financial crisis, CDSs came under
heightened scrutiny regarding threats to the stability of the financial system. At the time the crisis
hit, the opaqueness of the market and the sheer volume of CDSs outstanding contributed to the
unease felt by market participants, regulators, and the wider public.
60,000.00
50,000.00
40,000.00
30,000.00
20,000.00
10,000.00
1H012H011H022H021H032H031H042H041H052H051H062H061H072H071H082H081H092H091H102H101H112H111H12
3%
London
43%
39%
Europe ex-London
Asia/Australia
10%
US
Other
5%
Whether CDS played important role in causing the financial crisis or not is matter of great
debate. However, after the crisis, CDS have been under scrutiny from regulators around the
world and the market has witnessed a downward trend. As evident from the graph, the CDS
market has almost halved from its peak in 2007 for the reasons as discussed above.
7
The use of credit derivatives by region is as shown in the above pie chart.
Source: BBA
10
11
As evident from the above table, around one-third of the credit derivatives market is governed by
single-name CDS. The presence of other products mentioned illustrates the presence of other
complex credit derivatives product in the market.
12
13
The above figures A, B & C demonstrated the mechanics of a credit default swap contract under
two scenarios, which is not credit event (fig A) & in case of credit event (fig B & C)
The basic CDS contract is a "pure" credit risk transfer mechanism, isolating credit risk from
interest rate risk, foreign exchange risk and risk of security-specific technicals. There are two
parties to the contract:
-
Between trade initiation and default or maturity, protection buyer makes regular
payments to protection seller
In case of credit default, Payment of insurance following a credit event can occur in one of two
ways:
-
Physical Settlement
Cash Settlement
Cash settlement with an option for physical delivery has become the market standard.
Example: Simple CDS contract
An investment trust owns ` 10 Crore (` 100 million) corporation bond issued by a private
housing firm. If there is a risk the private housing firm may default on repayments, the
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investment trust may buy a CDS from a bank. 5 year CDS payable quarterly are trading at 160
bps.
So, the investment trust will make payments of: (0.0160/4) * ` 10,00,00,000 = ` 4,00,000
This is the quarterly payment made on this credit default swap.
If the private housing firm does not default, the bank gains the premium from the investment
trust and pays nothing out. If the private housing firm does default, then the bank has to pay
compensation to the investment trust of `10 Cr. less any amount recovered from the private
house.
Therefore the bank takes on a larger risk and could end up paying ` 10 Cr.
The following figure explains the payoff in the event of any default or no default. The two
scenarios explained are in case of cash settlement & physical settlement.
15
16
The guidelines were further revised (circular dt.7th January, 2013) as below:
i.
In addition to listed corporate bonds, CDS were also permitted on unlisted but rated
corporate bonds even for issues other than infrastructure companies.
ii.
Users were allowed to unwind their CDS bought position with original protection
seller at mutually agreeable or FIMMDA price. If no agreement was reached, then
unwinding had to be done with the original protection seller at FIMMDA price.
iii.
CDS were permitted on securities with original maturity up to one year like
Commercial Papers, Certificates of Deposit and Non Convertible Debentures with
original maturity less than one year as reference / deliverable obligations.
RBI in its recent circular (dt.23rd April, 2013) decided to permit All India Financial
Institutions, namely, Export Import Bank of India (EXIM), National Bank for Agriculture
17
and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries
Development Bank of India (SIDBI) to participate in the CDS market as user to hedge the
underlying credit risk in corporate bonds in their portfolio.
The protection buyer and the protection seller must be resident entities;
ii.
iii.
iv.
CDS shall not be written on entities which have not issued any bonds and have only
loan obligations;
v.
CDS shall not be written on securities with original maturity up to one year e.g., CP,
CD and NCD, etc.
vi.
Dealing in any structured financial product with CDS as one of the components and
any derivative product where the CDS itself is an underlying shall not be permitted;
vii.
18
4. No naked CDS
i.
ii.
iii.
5. Eligible Participants
Commercial Banks, stand alone Primary Dealers (PDs), Non-Banking
Market-makers*
Users
*Insurance companies and Mutual Funds are permitted as market-makers subject to their having strong financials
and risk management capabilities as prescribed by their respective regulators (IRDA and SEBI) and as and when
permitted by the respective regulatory authorities.
19
b) Minimum CRAR of 15% and have robust risk management systems in place to deal
with various risks.
Settlement methodologies
1. The parties to the CDS transaction shall determine upfront, the procedure and method of
settlement (cash/physical/auction) to be followed in the event of occurrence of a credit
event and document the same in the CDS documentation.
2. For transactions involving users, physical settlement is mandatory. For other transactions,
market-makers can opt for any of the three settlement methods (physical, cash and
auction), provided the CDS documentation envisages such settlement. While the physical
settlement would require the protection buyer to transfer any of the deliverable
obligations against the receipt of its full notional / face value, in cash settlement, the
protection seller would pay to the protection buyer an amount equivalent to the loss
resulting from the credit event of the reference entity.
3. Auction Settlement: Auction settlement may be conducted in those cases as deemed fit by
the DC. Auction specific terms (e.g. auction date, time, market quotation amount,
deliverable obligations, etc.) will be set by the DC on a case by case basis. If parties do
not select Auction Settlement, they will need to bilaterally settle their trades in
accordance with the Settlement Method (unless otherwise freshly negotiated between the
parties).
Pricing/Valuation methodologies for CDS
1. Market participants should put in place appropriate and robust methodologies for
marking to market the CDS contracts on a daily basis. These methodologies should be
validated by external validators periodically for reliability.
2. Market participants shall use FIMMDA published daily CDS curve to value their CDS
positions. Day count convention may also be decided by FIMMDA in consultation with
market participants. However, if a proprietary model results in a more conservative
valuation, the market participant can use that proprietary model.
3. For better transparency, market participants using their proprietary model for pricing in
accounting statements shall disclose both the proprietary model price and the standard
model price in notes to the accounts that should also include an explanation of the
rationale behind using a particular model over another.
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FIMMDA-NSE MIBID/MIBOR
ii.
FIMMDA-Reuters MIFOR
iii.
FIMMDA-Reuters MITOR
iv.
FIMMDA-Reuters MIOIS
v.
FIMMDA-Reuters MIOCS
vi.
vii.
Where these benchmarks are used for swap transactions, the same are used for valuing the swap.
Policy document on Valuation of CDS positions (FIMMDA)
The valuation methodology to be divided for Liquid Names and Other than Liquid Names:
1. Liquid Names
A. Traded Curve Points:
i. Validity Period: If the particular point on the curve is traded on the day of valuation,
the weighted average price for that day should be used for valuation.
ii. Threshold amount: The minimum traded threshold amount is 25 cr. i.e. traded data
will be used only if there have been trades for more than 25 cr.
B. Non-traded Curve Points: The CDS curve as provided by the Polling Agent to be used for
valuation. The Polling Agent superimposes all Traded Curve Points (after filtering for
Look-back period and Threshold Amount) over the results of its daily polling process to
provide one consolidated valuation curve for all Liquid Names.
This information is published by FIMMDA on its website on a daily basis. This data is to
be published by end-of-day on the same day.
21
b. This list will be provided on a monthly basis as approved by the FIMMDA Valuation
Committee.
c. The list of Liquid Names to contain a minimum of 5 and a maximum of 10 entities across
sectors.
2. Participants List
a. FIMMDA to provide a Participant List comprising of Market-Makers, Users and Brokers
to be polled for daily CDS price.
b. The number of participants will be a minimum of 5 and a maximum of 15
c. The mix of Market-Makers, Users and Brokers will be decided by FIMMDA Valuation
Committee and the list will be provided on a monthly basis to the Polling Agent.
d. The participants will be selected on a voluntary basis and if a minimum quorum of 5 is
not achieved, FIMMDA will nominate from amongst the market-makers.
3. Polling
FIMMDA to appoint an external vendor (Polling Agent) who will poll for CDS prices for
liquid names across tenors daily.
a. CDS prices to be polled will be flat spreads. The polled prices will be for a standard
recovery rate assumption, seniority in the capital structure and risk free curve which will
be provided to the polling agent.
(Flat Spreads is the market quotation standard. For example, if the flat spread for a 5Y
CDS is 150 bps, then 150 bps will be the spread assumed for all tenors from 1Y to 5Y for
valuation and calculation of upfront consideration)
b. Polling to be conducted for 1, 2, 5 and 10 years.
c. The polled data should be randomized, cleaned for outliers and CDS curves for each of
the liquid names will be calculated ( Polled Curves)
Procedure for calculation of CDS-Bond Basis
1. CDS curve points for Liquid Names daily are taken from Polled Curves
23
2. Corresponding bond spreads are taken from the daily published FIMMDA bond spread
matrix
3. CDS-Bond basis is calculated for each Liquid Name across tenors
4. Average CDS-Bond basis is calculated across tenors.
Example:
The CDS prices for liquid names are polled as below:
1Y
2Y
5Y
10Y
PFC
100
100
70
80
EXIM
100
105
72
78
REC
100
100
70
80
HDFC
IDFC
130
125
120
115
100
90
100
80
The bond spreads for the liquid names are taken from the FIMMDA Bond spread matrix for the
corresponding entity type. For example, PFC is of entity type PSU; so credit spreads for each
tenor is taken from the PSU category Bond Spread matrix
Credit Spread over G-Sec.
1Y
2Y
5Y
10Y
PFC
145
150
90
96
EXIM
135
145
88
94
REC
145
150
90
96
HDFC
175
170
120
120
IDFC
170
165
110
100
2Y
5Y
10Y
PFC
-45
-50
-20
-16
EXIM
-35
-40
-16
-16
24
REC
-45
-50
-20
-16
HDFC
-45
-50
-20
-20
IDFC
-45
-50
-20
-20
Average
-43
-48
-19
-18
25
The above table shows that we can calculate the probability of a bond rated Caa or below
defaulting during the third year as 39.717-30.494 = 9.223%. This is referred to as the
unconditional default probability. It is the probability of default during the third year as seen at
time 0. The probability that the bond will survive until the end of year 2 is 100 - 30.494 =
69.506%. The probability that it will default during the third year conditional on no earlier
default is therefore 0.09223/0.69506, or 13.27%. Conditional default probabilities are referred to
as default intensities or hazard rates.
Recovery Rates
When a company goes bankrupt, those that are owed money by the company file claims against
the assets of the company. Sometimes there is a reorganization in which these creditors agree to a
partial payment of their claims. In other cases the assets are sold by the liquidator and the
proceeds are used to meet the claims as far as possible. Some claims typically have priority over
other claims and are met more fully.
26
The recovery rate for a bond is normally defined as the bond's market value immediately after a
default, as a percent on its face value. The following table provides historical data on average
recovery rates for different categories of bonds in the United States.
It shows that senior secured debt holders had an average recovery rate of 54.44 cents per dollar
of face value while junior subordinated debt holders had an average recovery rate of only 24.47
cents per dollar of face value. Recovery rates are significantly negatively correlated with default
rates.
Moody's looked at average recovery rates and average default rates each year between 1982 and
2006. It found that the following relationship provides a good fit to the data:
Recovery rate = 59.1 - 8.356 x Default rate
This relationship means that a bad year for the default rate is usually doubly bad because it is
accompanied by a low recovery rate. For example, when the average default rate in a year is only
0.1 %, the expected recovery rate is relatively high at 58.3%. When the default rate is relatively
high at 3%, the expected recovery rate is only 34.0%.
expecting to lose 200 basis points (or 2% per year) from defaults. Given the recovery rate of
40%, this leads to an estimate of the probability of a default per year conditional on no earlier
default of 0.02/(1- .0.4), or 3.33%.
In general,
Where,
is the average default intensity (hazard rate) per year, s is the spread of the
corporate bond yield over the risk-free rate, and R is the expected recovery rate.
Default Prob.
Survival
Prob.
2.00%
98.00%
1.96%
96.04%
1.92%
94.12%
1.88%
92.24%
1.84%
90.39%
The probability of a default during the first year is. 0.02 & the probability the reference entity
will survive until the end of the first year is 0.98. The probability of a default during the second
year is 0.02 x 0.98 = 0.0196 and the probability of survival until the end of the second year is
0.98 x 0.98 ~ 0.9604. The probability of default during the third year is 0.02 x 0.9604 = 0.0192,
and so on.
To understand the calculations better, we simply assume that defaults always happen halfway
through a year and that payments on the credit default swap are made once a year, at the end of
28
each year.
Assume that the risk-free (LIBOR) interest rate is 5% p.a. with continuous
Now, there are three parts to the calculation. Assuming that payments are made at the rate of s
per year and the notional principal is $1, we calculate the following,
A. P.V. of the expected payments made on the CDS: There is a 0.9412 probability that the
third payment, s is made. The expected payment is therefore 0.9412s and its present value
= 0.9412s x e-0.05s
x 3
4.070s.
PAYMENT
Expected Payments
Tim
e
Survival
Prob.
Discount
Factor
Prob. of
survival
PV
1.0
98.0%
0.951
98.0%
0.932
2.0
96.0%
0.905
96.0%
0.869
3.0
94.1%
0.861
94.1%
0.810
4.0
92.2%
0.819
92.2%
0.755
5.0
90.4%
0.779
90.4%
0.704
Tot
al
4.070
B. P.V. of the expected payoff on CDS: We are assuming that defaults always happen
halfway through a year. Now, there is a 0.0192 probability of a payoff halfway through
the third year. Given that the recovery rate is 40% the expected payoff at this time is
0.0192 x 0.6 x 1 = 0.0115. The present value of the expected payoff = 0.0115 x e -0.05s x 2.5 =
0.0102. The total present value of the expected payoffs is $ 0.0511.
29
PAYOFF
Expected Payof
Time
Default
Prob.
Discount
Factor
% of Notional
PV in
($):
0.5
2.00%
0.975
1.20%
0.012
1.5
1.96%
0.928
1.18%
0.011
2.5
1.92%
0.882
1.15%
0.010
3.5
1.88%
0.839
1.13%
0.009
4.5
1.84%
0.799
1.11%
0.009
Total
0.0511
C. Accrual payment made in the event of a default: Say from table, there is a 0.0192
probability that there will be a final accrual payment halfway through the third year. The
accrual payment is 0.5s. The expected accrual payment at this time is therefore 0.0192 x
0.5s = 0.0096s. Its present value is 0.0096s x e -0.05 x 2.5 = 0.0085s. The total present value
of the expected accrual payments is 0.0426s.
PAYMENT
Expected Accrual
Time
% of
p.a.
PV of:
0.5
1.00%
0.010
1.5
0.98%
0.009
2.5
0.96%
0.008
3.5
0.94%
0.008
4.5
0.92%
0.007
30
Total
0.0426
From calculation A & C, the present value of the expected payments is 4.070s + 0.0426s =
4.1130s
From calculation B, we got the present value of the expected payoff is 0.0511.
Equating the two gives: 4.1130s = 0.0511 or s = 0.0124
Thus, the mid-market CDS spread for the 5-year deal we have considered should be 0.0124 times
the principal or 124 basis points per year.
It is important to note that in practice, the calculations are more extensive than the ones
illustrated here as,
a. Payments are often made more frequently than once a year and
b. Defaults can happen more frequently than once a year.
31
32
Conclusion
The credit default swaps (CDS) guidelines by the Reserve Bank of India (RBI) augurs well for
the development of India's bond markets. The introduction of CDS is expected to lead to
deepening of the corporate debt market. At the same time we can also see that RBI has set
adequate safeguards in place in the regulatory framework to ensure systemic stability and safety.
Introduction of CDS is expected to catalyze the Indian corporate bond market in three ways:
CDS can expand the bond market investors' appetite for lower rated issuers, as against their
current preference for higher-rated securities. Since investors are now protected against any
change in the credit quality of their investments, they will be more open to invest in instruments
rated below AA category. Second, over the medium term, an increased usage of CDS has a
potential to impart additional liquidity to the debt market, which has so far been predominantly
illiquid. Third, an additional focus on infrastructure sector is reflected in the fact that CDS for
infrastructure companies can be written on even unlisted bonds. The protection for investors is
further enhanced by including even referral to BIFR and CDR as credit events. Intermediaries
benefit by facilitating medium-sized companies to raise funds from the debt capital markets.
Further, CDS enhances their investment avenues beyond the traditional avenues in the high
safety category. Investors can now invest in such higher-yield instruments, while ensuring
minimal credit risk by buying CDS protection from top-rated counterparties. Further, CDS
protection insulates investors from India's weak debtor recovery mechanism, even in the event of
any default or bankruptcy of the bond issuer. This is because the credit events, as defined in the
CDS contract, include bankruptcy and restructuring approved by BIFR as well as CDR
mechanism.
This is an opportune time for the introduction of CDS in India, as the rated portfolio has
expanded across all rating categories. Market participants are, therefore, better equipped today
than ever before to take well-informed decisions on the future direction of an issuer's credit
quality. This will encourage more market participants to sell CDS protection. The regulatory
framework proposed by RBI balances the need for systemic stability and safety, while
introducing such innovative product in India.
33
References
Websites Referred
1. www.rbi.org.in
2. www.fimmda.org
3. www.bba.org.uk
4. www.isda.org
5. www.moodys.com
6. www.bloomberg.com
7. www.reuters.com
8. www.indianexpress.com
9. www.articles.economictimes.indiatimes.com
10. www.brickworkratings.com
Reports Referred:
1. Book on Options, Futures & Other Derivatives by John C. Hull
2. Article by J P Morgan on Guide to Credit Derivatives
34