Professional Documents
Culture Documents
Praveen P. Mishall
MMS 2008-10
Welingkar Institute of Management Development & Research
praveen.mishall@gmail.com
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Credit Default Swaps 8/18/2009
Agenda
What are Derivatives?
What are Credit Derivatives?
What are Credit Default Swaps
Subprime Crisis and its implications
Role of CDS in Subprime Crisis
CDS Auction
CDS Data Sources
Central Counterparty Settlement for CDS
Credit Derivatives Market in India
CDS and its settlement in India
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Credit Default Swaps 8/18/2009
Derivatives Derivatives Contract Types
– Forward & Future
What are Derivatives? – Options
– Derivatives are financial – Swaps
contracts, or financial
instruments, whose prices
Risks with Derivatives
are derived from the price – Large losses due to leverage
of underlying. – Counterparty risk
Uses of Derivatives – Large notional amounts
– Hedging – Complicated nature of
– Speculation Derivatives
– Arbitrage Driving forces for growth
Types of Derivatives – Volatility in asset prices
– OTC Derivatives – Integration of national
market with international
– Exchange Traded
Derivatives – Communication facilities
– Risk Management Tools
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Credit Default Swaps 8/18/2009
OTC Derivatives Growth
“Blaming derivatives for financial losses is akin to blaming cars for drunken driving fatalities”
Christopher L. Culp
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Credit Default Swaps 8/18/2009
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Credit Derivatives
What are Credit Derivatives?
– Credit derivatives can be defined as arrangements that allow one
party (protection buyer or originator) to transfer, for a premium,
the defined credit risk, or all the credit risk, computed with
reference to a notional value, of a reference asset or assets, which
it may or may not own, to one or more other parties (the
protection sellers).
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Credit Default Swaps 8/18/2009
Credit Default Swap
Types of CDS Speculation in CDS
– Single-name CDS – Structured Investment
– Multi-name CDS Vehicle (SIV) market
Settlement Methods – Naked CDS
– Secondary market for CDS
– Physical Settlement
– Cash Settlement How is CDS different
– Fixed Amount Settlement
from insurance?
– Seller is not regulated entity
Uses of CDS
– No need to own reference
– Hedging
entity
– Speculation
– No need to maintain
reserves for pay-off
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Credit Default Swaps 8/18/2009
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CDS Pricing
Value of CDS (to the protection buyer) = PV [contingent leg] –
PV [fixed (premium) leg]
Where,
D(ti) = Discounting
Factor,
q(ti) = Survival
Probability,
S = CDS Premium,
di = Accrual days as a
fraction of a year,
{q(ti-1) - q(ti)} =
Survival Probability till
credit default event,
R = Recovery Rate.
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Credit Default Swaps 8/18/2009
Securitization Process
Source: Infosys
Source:YieldCurve.com
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Credit Default Swaps 8/18/2009
CDS Statistics
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Credit Default Swaps 8/18/2009
The Changes in CDS Market
Central Counterparty
Hardwiring the Auction Protocol
ISDA Determination Committee
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Credit Default Swaps 8/18/2009
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CDS Auction
Rationale behind Auction Process
– Physical Settlement of CDS contracts
– CDS outstanding greater than the volume of bonds issued
– Artificial rise in the price of the bonds
– Need for transparent, trustworthy price for Cash Settlement
– Elimination of Basis Risk
Overview of CDS Auction Process
CDS Auction – Stage 1 Stage 1 Results published are –
– 2-way market quotes – The inside market midpoint
– Physical settlement request – The size and direction of the
– Inside Market Midpoint open interest
– Open Interest – Any Adjustment Amounts
CDS Auction – Stage 2
– matching open interest and
creating a final price
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Credit Default Swaps 8/18/2009
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Auction Process: Lehman Brothers
Quotation Size
– $5 million
Inside Market Midpoint
– 9.75
Open Interest –
$4.92 billion to sell
Adjustment Amount
– $12500
Final Settlement Price
– 8.625
Note: Prices are expressed relative to a par value of 100
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Credit Default Swaps 8/18/2009
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CDS Data Sources
International Swaps and The Office of the Comptroller
Derivatives Association of the Currency
– ISDA Master Agreement – Quarterly report on bank
– Administrating Auction Process derivatives activities in US
– ISDA Determination committee – OCC shared the regulatory
information on CDS after its
– Semiannual Reports introduction to market
Bank for International The Depository Trust and
Settlement Clearing Corporation
– BIS semiannual data for single- – Trade Information Warehouse,
name, multi-name instruments comprehensive trade database
– CDS by counterparty, sector and – Weekly information on credit
rating derivative products, transaction
British Bankers' Association types, etc.
– Reports every two years on credit Other data sources –
derivatives activities in London/ – Bloomberg, Markit, S&P,
Europe Moodys, Fitch Rating, etc.
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Credit Default Swaps 8/18/2009
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Central Counterparty Settlement
TriOptima
IntercontinentalExchange Trust
NYSE Euronext LIFFE &
LCH.Clearnet SA
CME Group Inc./ Citadel
Investment Group
Eurex AG.
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Credit Default Swaps 8/18/2009
Comparison of CCPs
NYSE Euronext CME
Parties ICE Trust/ CCorp Eurex AG
LIFFE/ LCH Group/Citadel
Program
CCP CCP E-trading & CCP CCP
Type
Presence in US/ Europe Europe Europe/ US Europe
Started on 09/03/2009 22/12/2008 Yet to start Yet to start
Eurex clearing
Pricing by Markit Markit Markit pricing team,
Markit
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Credit Default Swaps 8/18/2009
Comparison of CCPs
ICE Trust/ NYSE Euronext
Parties CME Group/Citadel Eurex AG
CCorp LIFFE/ LCH
Leverage of existing
Integration Novation within Open architecture, enabling OTC CDS and Eurex
and co- a Eurozone legal market participants to Clearing infrastructure
existence framework execute or book CDS trades No additional technical
with other LCH.Clearnet through party-to-party connectivity required for
elements of SA to act as the negotiation, IDB brokered, existing Clearing
CDS CCP CMDX Request for Quote Members, STP
Features processing (RFQ) platform, or other processing with the
ISDA
infrastructur documentation electronic matching venues DTCC Deriv/SERV
e (like compliance Migration Utility to migrate Trade Information
DTCC) DTCC TIW as existing bilateral OTC Warehouse
central registrar contracts to standardized, Dedicated clearing fund
centrally cleared contracts for CDS
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Credit Default Swaps 8/18/2009
General Global Settlement Procedure
Functional Model
– DTCC TIW for trade
capturing,
confirmation and
settlement
– Check various criteria
before novation by
central counterparty
Trade Lifecycle
– Flags, novation,
netting, collateral,
etc.
CDS Pricing Risk Management End of day processing
– Markit pricing info. Model – Reports with current
– Eurex clearing – Margins & positions, margin
pricing team Collaterals summary, collateral
reports
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Credit Derivatives Market in India
Need for Credit Derivatives Benefits of credit derivatives
– Eliminate uneven distribution – Transfer credit risk & free up
of risk in market capital by banks
– Banks & FIs highly skewed – Retaining existing client
with loan portfolios with no relationship
bond portfolio – Construct & manage the credit
– Mutual funds, Hedge funds, risk portfolio of own choice
Insurance companies & – Diversification of credit risk
Pension funds mostly have Minimum Conditions
bond portfolio and no loan
portfolio – Direct
Expected Participants – Explicit
– Banks, Financial Institutions, – Irrevocable
Insurance companies, Mutual – Unconditional
funds
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Credit Default Swaps 8/18/2009
RBI Draft Guidelines
Participants allowed Product Requirements
– Protection buyers: – Credit Events
Commercial Banks, Primary Bankruptcy
Dealers Obligation Acceleration
– Protection seller: Commercial Obligation Default
Banks, Primary Dealers Failure to pay
Product Requirements Repudiation/ Moratorium
– Protection buyer must have a Restructuring
credit risk exposure – Minimum Requirements
– Settlement Methods Direct, Explicit, Irrevocable
Physical Settlement
& unconditional
No recourse to protection
Cash Settlement
buyer for losses
Fixed Amount Settlement
Specified post-credit-event
– ISDA Master Agreement valuation period
compliance
Legal enforceability
Continued… 26
Credit Default Swaps 8/18/2009
RBI Draft Guidelines
Product Requirements Risk Management
– Minimum Requirements – Sound risk management policies &
Credit events specified at procedures (due diligence)
minimum are – – Counterparty limits by PBs
- Failure to pay – Awareness of legal risk
- Bankruptcy, insolvency – Adequate oversight by Board of
- Restructuring Directors and senior management
– Seniority of underlying Procedures
– Right/Ability to transfer – Measuring, monitoring, reviewing,
underlying asset/obligation reporting and managing the risks
– Grace period < Loan period – Analysis & minimization of risk
– Protection buyer has right to – Management of market risk in
inform Protection Seller about trading books
the occurrence of credit event – Management of legal risk
– Management of liquidity reserve
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CDS and its settlement in India
Feelers sent out to many banks to check the acceptability
Possible CDS Settlement –
– OTC Market
– Trade Reporting Platform
– Once market matures Central Counterparty Settlement
Role of CCIL
Some issues to be addressed are –
– Regulatory approvals for insurance companies & mutual funds to
maximize the number of participants
– More lights on restructuring as credit event
– Clear distinction between insurance contracts and CDS contracts
“There is surely a need for such a product (CDS)”
- Ashish Vaidya, Head of interest rate trading, HDFC Bank.
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Credit Default Swaps 8/18/2009
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References
BIS Quarterly Review – BIS
CDS Trading and Clearing Solution – CME Group
Credit Default Swap – Wikipedia
A simple explanation of the subprime crisis – David Waring (InformedTrade)
Derivative (finance) – Wikipedia
CDS: changing the contract – HSBC Global Research
Draft CDS Guidelines – RBI
European OTC Clearing Solution for CDS – Eurex Clearing
Options, Futures and Other Derivatives – John C. Hull
Credit Default Swap (CDS) Primer – Nomura Fixed Income Research
OCC's Quarterly Report on Bank Derivatives Activities – OCC
Report of the Working Group on Introduction of Credit Derivatives in India –
Department of Banking Operations and Development
Subprime Mortgage Crisis – Wikipedia
Introduction to Credit Derivatives – Vinod Kothari
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Credit Default Swaps 8/18/2009
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Thank You
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Credit Default Swaps 8/18/2009