Project Report on

Understanding Credit Default Swaps: Valuations & Regulatory Environment

Submitted ByDEWANG DOSHIROLL NO. 08

Master of Management Studies2011 2013

Under The Guidance ofPROF. APARNA BHAT

University of MumbaiK J Somaiya Institute of Management Studies & ResearchVidyanagar, Vidyavihar (E), Mumbai 400 077

Project Report on

UNDERSTANDING CREDIT DEFAULT SWAPS: VALUATIONS & REGULATORY ENVIRONMENT

Submitted ByDEWANG DOSHIROLL NO. 08

IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FORMASTER OF MANAGEMENT STUDIES2011 2013

UNDER THE GUIDANCE OFPROF. APARNA BHAT

UNIVERSITY OF MUMBAIK J SOMAIYA INSTITUTE OF MANAGEMENT STUDIES & RESEARCHVIDYANAGAR, 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

I, Dewang Doshi, a student of M.M.S Finance, Semester IV of University of Mumbai, batch 2011-2013 from K J Somaiya Institute of Management Studies & Research (SIMSR) do hereby declare that this report titled Understanding Credit Default Swaps: Valuations & Regulatory Environment, carried out by me during this semester under guidance of Prof. Aparna Bhat is as per the norms prescribed by University of Mumbai & the same work has not been copied directly without acknowledging for the part / section that has been adopted from published/ non-published works & is true to the best of my knowledge.

Date: Place: MumbaiDewang Doshi

CERTIFICATE

I, Prof. Aparna Bhat, hereby certify that Mr. Dewang Doshi studying in the 2nd 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: MumbaiProf. Aparna Bhat

TABLE OF CONTENTS

Introduction1Introduction to Credit Derivatives1Introduction to Credit Default Swaps (CDS)2Important Terminologies for CDS2Credit Default Swaps: Market at Glance4Evolution of CDS market4Major players in the CDS market6Various forms of CDSs7Global Credit Derivatives Product Usage9Mechanics of CDS Contract10Example: Simple CDS contract11CDS Guidelines for India13Objective of RBI:13Evolution of CDS market in India13Guidelines by RBI: Overview14Eligibility norms for market-makers15Settlement methodologies15Pricing/Valuation methodologies for CDS16Pricing/ Valuation Methodology of FIMMDA16Policy document on Valuation of CDS positions (FIMMDA)17Process followed by FIMMDA for valuation curves:18Procedure for calculation of CDS-Bond Basis19Valuation of CDS contracts:22Historical Default Probabilities:22Recovery Rates22Estimating Default Probabilities from Bond Prices23Illustration of CDS valuation24Risks associated with CDS27CDS in Indian Markets: The way forward28

IntroductionIntroduction to Credit DerivativesThe 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 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.Introduction to Credit Default Swaps (CDS)Credit Default Swap is a contract that provides insurance against the risk of a default by particular company. It is a bilateral financial contract in which one counterparty (Protection Buyer) pays a periodic fee, typically expressed in basis points per annum, which is paid on the notional amount, in return for a contingent Payment by the Protection Seller following a Credit Event with respect to a Reference Entity. The total face value of the bonds that can be sold is known as the credit default swap's notional principal.The definitions of a Credit Event, the relevant Obligations and the settlement mechanism used to determine the Contingent Payment are flexible and determined by negotiation between the counterparties at the inception of the transaction.The market has now evolved into a standardized terms credit derivatives market & it has been a major development because it has reduced legal uncertainty that in the early stages hampered the markets growth. This uncertainty arose because credit derivatives are frequently triggered by a defined (and fairly unlikely) event rather than a defined price or rate move, making the importance of legal documentation for such transactions commensurately greater.Important Terminologies for CDS 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 Term: Maturity of credit protection 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 EventA 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. Argentinaii. Bankruptcy (for non-sovereign entities) or Moratorium (for sovereign entities only), e.g. Delphi, Delta Airlines, Northwest Airlinesiii. Repudiation ,iv. Material adverse restructuring of debt (not included in North American contracts), e.g. Xerox, Consecov. Obligation Acceleration or Obligation Default. While Obligations are generally defined as borrowed money, the spectrum of Obligations goes from one specific bond or loan to payment or repayment of money, depending on whether the counterparties want to mirror the risks of direct ownership of an asset or rather transfer macro exposure to the Reference entity.

Credit Default Swaps: Market at GlanceEvolution of CDS market

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.

Source: ISDA Market Survey (2001~10), DTCC (2010~12)

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. The use of credit derivatives by region is as shown in the above pie chart.

Major players in the CDS marketIn contrast to publicly traded securities, OTC derivatives are almost exclusively traded bilaterally through a network of (private) dealers usually amongst a group of major banks and securities houses.4 Dealers stand ready to trade and take positions in various underlying risks, while maintaining a limited net exposure. Market concentration among dealers is high and may have increased as a consequence of major participants exiting the market. DTCC data warehouse states that almost 50% of the total notional amount sold may be attributable to the top five dealersApart from their role as dealers, banks use CDSs mainly for managing their own loan portfolios. For instance, a smaller commercial bank may buy credit protection from a CDS dealer in order to hedge its exposure to a certain corporate borrower. Banks, securities houses, hedge funds and other institutional traders use CDSs also for proprietary trading purposes. Besides banks and security houses, hedge funds constitute a major force in the CDS market.In contrast to banks and hedge funds, which can be found on both sides of the market, (monoline) insurers such as Ambac or MBIA and large CDS sellers such as AIG provide credit protection but have limited activities in the buy side of the market. Source: BBAVarious forms of CDSs Credit default swaps can come in various forms depending on the underlying reference entity and any other varying contractual definitions. The two most commonly used groups include CDSs based on single-name corporate or sovereign borrowers, and CDSs referenced to various entities (multi-name CDSs). Single-name and multi-name CDSs constitute also the dominant form of credit derivatives the wider category to which CDSs belong. While single-name contracts account for the majority of all trades, multi-name contracts have become almost as popular during recent years. The rapid growth of this market segment is due to index trades being used increasingly for trading purposes as well as for proxy hedges. Besides plain CDSs, such as single-name or index CDSs, more sophisticated products exist. Credit derivatives include also funded and unfunded synthetic collateralized debt obligations (CDOs) offering tranched claims to a portfolio of CDSs, or in the form of tranched index CDSs on a CDS index. In addition to the CDS spot market there is also a market for options and forwards written on CDSs. Options on CDSs, so called Credit Swaptions, give the buyer the right but not the obligation to receive or sell protection for a predetermined premium, whereas CDS forwards oblige the parties to buy or sell CDS protection in future at a certain price. Source: Deutsche Bank

Global Credit Derivatives Product Usage

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.

Mechanics of CDS Contract

Fig A: CDS Contract Mechanics - No Credit Event

Fig B: CDS Contract Mechanics (After Credit Event) - Physical Settlement

Fig C: CDS Contract Mechanics (After Credit Event) - Cash Settlement

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: Protection buyer (seller of credit risk) and Protection seller (buyer of credit risk)

There are following conditions for a CDS contract: Between trade initiation and default or maturity, protection buyer makes regular payments to protection seller The spread is calculated on the notional amount of protection Typically paid quarterly Payments terminate at maturity or following a credit event 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 contractAn 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 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 = ` 4,00,000This 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.

Cash settled Credit Default Swap

Physically settled Credit Default Swap

CDS Guidelines for IndiaObjective of RBI:The objective of introducing Credit Default Swaps (CDS) on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk. CDS as a risk management product offers the participants the opportunity to hive off credit risk and also to assume credit risk which otherwise may not be possible. Since CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers, such products would increase investors interest in corporate bonds and would be beneficial to the development of the corporate bond market in India.

Evolution of CDS market in India In May 2011, RBI had allowed the introduction of only traditional plain vanilla CDS product with the underlying initially restricted to listed corporate bonds. CDS on unlisted bonds were specifically allowed only for infrastructure companies.

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 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.

Guidelines by RBI: Overview1. The single-name credit default swaps on corporate bonds in India must satisfy the following requirements:i. The protection buyer and the protection seller must be resident entities;ii. The reference asset/obligation and the deliverable asset/obligation must be to a resident and denominated in Indian Rupees; the CDS contract must be denominated and settled in Indian Rupees;iii. Underlying reference obligations such as asset-backed securities/mortgage backed securities, convertible bonds, zero coupon bonds, bonds with amortizing structure and call/put option shall not be permitted;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. It is mandatory for the CDS buyers to have bonds in de-materialized form as underlying.

2. Only Indian Resident or Registered FIIs can write a CDS.

3. CDS can be used only for hedging or buying protection.

4. No naked CDSi. Hold Reference Obligation or Unwindii. CDS protection value cannot be greater than FV of Reference Obligation iii. CDS tenor cannot exceed Reference Obligation maturity

5. Eligible Participants Market-makers*Commercial Banks, stand alone Primary Dealers (PDs), Non-Banking Financial Companies (NBFCs) having sound financials and good track record in providing credit facilities and any other institution specifically permitted by the Reserve Bank.

UsersCommercial Banks, PDs, NBFCs, Mutual Funds, Insurance Companies, Housing Finance Companies, Provident Funds, Listed Corporates, Foreign Institutional Investors (FIIs) and any other institution specifically permitted by the Reserve Bank.

*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.Eligibility norms for market-makersA. Commercial banks:a) Minimum CRAR of 11% with core CRAR (Tier I) of at least 7%; b) Net NPAs of less than 3%. B. NBFCs: a) Minimum Net Owned Funds of Rs. 500 crore; b) Minimum CRAR of 15%; c) Net NPAs of less than 3% and have robust risk management systems in place to deal with various risks. C. PDs :a) Minimum Net Owned Funds of Rs. 500 crore; 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. Pricing/ Valuation Methodology of FIMMDACredit Default Swap valuation in India is done as per the data released by Fixed Income Money Market and Derivatives Association of India (FIMMDA).FIMMDA publishes the following benchmarks on a daily basis. i. FIMMDA-NSE MIBID/MIBOR ii. FIMMDA-Reuters MIFOR iii. FIMMDA-Reuters MITOR iv. FIMMDA-Reuters MIOIS v. FIMMDA-Reuters MIOCS vi. FIMMDA-Reuters Commercial Paper vii. FIMMDA-Reuters Treasury Bill 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 NamesA. 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.2. Other than Liquid NamesA. Traded Curve Points: i. Validity Period: If the particular tenor on CDS has traded in any of the past 15 days, such most recent traded CDS price 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. on the day of trade.B. Non-traded Curve Points: i. The corporate bond spread matrix (published by FIMMDA) for the relevant sector type is takenii. CDS-Bond Basis (published by FIMMDA) is applied to the spread matrix to arrive at the CDS price for valuation. The Polling Agent will consolidate all Traded Curve Points from CCIL (after filtering for Validity period and Threshold amount ) and provide a list of name-wise traded curve points. The Polling agent will also provide the average bond basis across tenors.This information is published by FIMMDA on its website on a daily basis 3. CDS trades for tenors more than 10 years will be valued at the 10 yr point i.e. curve will be assumed to be flat after 10 years.4. Market participants will have discretion of 25 bps above/ below the CDS spread determined for valuation using the above methodology for up to AA rating and 50 bps for AA- and below. The rating to be used for this purpose will be the credit rating of the Reference Obligation.5. The applicable credit rating (of the Reference Obligation) will be the lowest available public rating (among the SEBI-registered accredited credit rating agencies), who have rated the Reference Obligation.Process followed by FIMMDA for valuation curves:1. Liquid Namesa. FIMMDA to publish a list of Liquid names along with the sector classification.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 Lista. 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 15c. 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. PollingFIMMDA 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 Basis1. CDS curve points for Liquid Names daily are taken from Polled Curves2. Corresponding bond spreads are taken from the daily published FIMMDA bond spread matrix3. CDS-Bond basis is calculated for each Liquid Name across tenors4. Average CDS-Bond basis is calculated across tenors.Example:The CDS prices for liquid names are polled as below:1Y2Y5Y10Y

PFC1001007080

EXIM1001057278

REC1001007080

HDFC130120100100

IDFC1251159080

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 matrixCredit Spread over G-Sec.1Y2Y5Y10Y

PFC1451509096

EXIM1351458894

REC1451509096

HDFC175170120120

IDFC170165110100

Finally, the CDS-Bond Basis is calculated as below:CDS-Bond Basis1Y2Y5Y10Y

PFC-45-50-20-16

EXIM-35-40-16-16

REC-45-50-20-16

HDFC-45-50-20-20

IDFC-45-50-20-20

Average-43-48-19-18

FIMMDA will publish the following data daily:1. The sector-specific corporate bond spread matrices (across ratings and tenors)2. The CDS curves for individual Liquid Names3. The CDS-Bond Basis curve as calculated above to be applied to Other than Liquid Names4. Traded curve points to be used for valuation of Other than Liquid Names

Valuation of CDS contracts:Historical Default Probabilities:

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 RatesWhen 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. 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 rateThis 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%.

Estimating Default Probabilities from Bond PricesThe probability of default for a company can be estimated from the prices of bonds it has issued. The usual assumption is that the only reason a corporate bond sells for less than a similar risk-free bond is the possibility of default Suppose that a bond yields 200 basis points more than a similar risk-free bond and that the expected recovery rate in the event of a default is 40%. The holder of a corporate bond must be 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.Illustration of CDS valuationSuppose that the probability of a reference entity defaulting during a year conditional on no earlier default is 2%. The table below shows survival probabilities and unconditional default probabilities (i.e., default probabilities as seen at time zero) for each of the 5 years of CDS contract. TimeDefault Prob.Survival Prob.

12.00%98.00%

21.96%96.04%

31.92%94.12%

41.88%92.24%

51.84%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 each year. Assume that the risk-free (LIBOR) interest rate is 5% p.a. with continuous compounding and the recovery rate is 40%.

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 = 0.8101s. The total present value of the expected payments is 4.070s.

PAYMENT

Expected Payments

TimeSurvival Prob.Discount FactorProb. of survivalPV

1.098.0%0.95198.0%0.932

2.096.0%0.90596.0%0.869

3.094.1%0.86194.1%0.810

4.092.2%0.81992.2%0.755

5.090.4%0.77990.4%0.704

Total4.070

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.PAYOFF

Expected Payoff

TimeDefault Prob.Discount Factor% of NotionalPV in ($):

0.52.00%0.9751.20%0.012

1.51.96%0.9281.18%0.011

2.51.92%0.8821.15%0.010

3.51.88%0.8391.13%0.009

4.51.84%0.7991.11%0.009

Total0.0511

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:

0.51.00%0.010

1.50.98%0.009

2.50.96%0.008

3.50.94%0.008

4.50.92%0.007

Total0.0426

From calculation A & C, the present value of the expected payments is 4.070s + 0.0426s = 4.1130sFrom calculation B, we got the present value of the expected payoff is 0.0511. Equating the two gives: 4.1130s = 0.0511 or s = 0.0124Thus, 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 andb. Defaults can happen more frequently than once a year.

Risks associated with CDSi. Basis Risk: Arises from imperfect hedges when there is a risk of a loss due to differences in the underlying position and the hedge.ii. Counterparty risk credit risk: The risk that the counterparty to a CDS contract will default and not meet its contractual payment obligations.iii. Counterparty risk pre settlement risk: Arises when protection seller does not receive contractual premium payments if protection buyer goes bankrupt.iv. Wrong way risk: The probability of simultaneous default of both the reference entity and the protection seller. It is dependent on the default correlation between the protection seller and reference entity and the marginal probability of default of either the reference entity or the protection seller.v. Credit spread risk: A measure of the sensitivity of the marked-to-market changes, i.e. the impact of a one basis point shift of the spread curve on the position due to the underlying credit spread risk factors of the primary bond and the single-name CDS.vi. Concentration risk: Results from disproportionately large net exposure in similar types of CDS. vii. Operational risk: Arises due to the number of steps required to process the CDS trade such as unconfirmed trades, valuation of CDS contract, physical settlement, related IT infrastructure and non-availability of skilled manpower.viii. Jump-to-default risk: The risk that the sudden occurrence of a credit event will cause an abrupt change in a firms CDS exposure.ix. Legal risk: This may arise due to non-adherence to the legal framework (laws, guidelines, etc.) prevailing in the country.

ConclusionThe 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.

ReferencesWebsites Referred1. www.rbi.org.in2. www.fimmda.org3. www.bba.org.uk4. www.isda.org5. www.moodys.com6. www.bloomberg.com7. www.reuters.com8. www.indianexpress.com9. www.articles.economictimes.indiatimes.com10. www.brickworkratings.com

Reports Referred:1. Book on Options, Futures & Other Derivatives by John C. Hull2. Article by J P Morgan on Guide to Credit Derivatives

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ProductPercentage

Single-name credit default swaps29.3%

Credit spread options2.1%

Swaptions1.0%

Variance Swaps0.1%

Credit-linked notes (cash-backed & repackaged notes) 3.3%

Synthetic CDOs (over 10 names) full capital structure 2.9%

Synthetic CDOs (over 10 names) partial capital/single tranche 12.9%

Basket products (up to 10 names) 1.1%

Full index trades 29.4%

Tranched index trades 9.9%

Equity linked credit products (e.g. equity default swaps) 0.9%

Credit Contingent Swaps 0.7%

Constant Maturity Swaps 0.9%

CPPI 2.0%

Credit Option / Bond Option 1.6%

Binary CDS 2.2%

Other 0.3%