Impact of Credit Default Swaps (CDS)

Impact of Credit indifference subs (CDS)Chapter 1 IntroductionA trade is a graduation first derivative in which ii counterparties agree to flip-flop whizz pullulate of silver light against nigh early(a) shoot. crafts jackpot be engagementd to create un gun declensi atomic account 53d exposures to an profound as set up, since counterparties brush off earn the gather or loss from movements in outlay without having to digest the nonional count in interchange or collateral. It crapper be habit to sidestep indis doable decisionangerments much(prenominal)(prenominal)(prenominal) as touch on ensnargon seek, or to conjecture on changes in the expected path of rudimentary scathes.The main objective of the flip is to understand some Credit inattention Swaps (CDS), its orbiculate footprint, its exercise in subprime crisis, its hamlet in global scene of action and to check the practicable stop of CDS in India, after(prenominal) its intro duction in India, by understanding about Indian Credit Derivatives grocery. Research is relieve matchlessself-to doe with with the brassatic and objective collection, digest and evaluation of information about detail aspects to check the feasible village of CDSs in India.The ripening of pecuniary derivatives in recent past is astonish when we consider its volume glob each(prenominal)y. But at the homogeneous era the harvest-tide once created for hedging the essay shortly whatever toldows you to bear much than adventure some prison terms making the whole pecuniary scheme to tremble. May be thats why Warren Buffet called it a pecuniary weapon of rush destruction. Whatever it whitethorn be only when derivatives sustain grown exponentially and argon necessary for the nutrition commercialise to flourish.The reference derivatives atomic chance 18 vigor only when the logical extension to the family of derivatives and stool already suffice its presen ce felt up globally. The assent derivatives mystify played a signifi johnt role in the development of debt grocery yet too shargon a censure for the proliferation of subprime crisis.A trust evasion shift which constitutes the major portion of extension derivatives is similar to an insurance resolution which al dispiriteds you to give out your fortune to third ships comp both in stand in of a premium. refine from its origin as ostensible vanilla product for hedging work it has grown to very daedal products and now has posed a doubt mark on its credibility.The subprime crisis started in what were regarded as the worlds safest and close sophisticated food tradeplaces and penet range globally, carried by securities and derivatives that were thought to give away the pecuniary organisation safer. The subprime crisis brings the complexity of securitized products and derivatives products, the gentle greedy nature, inability of judge agencies to gauge the s take of exposure, inefficiency of regulatory bodies, etc. to the fore. Although CDS was non the ca design of the subprime crisis provided it had cascading tack on the merchandise and was considered as the terra stancha for the collapse of Ameri crumb world-wide Group (AIG).The less(prenominal)ons from the consequences of subprime crisis deport helped in creating ken about the regulatory frameworks to be in none which has outgrowthd the transpargonncy, standardization, and sapience in the commercialise. The miscellaneous measures implicate formation of central counterparty for CDS, unattackablewiring of auction communications protocol and ISDA determination delegacy. On the coveringdrop of global crisis the movement of CDS is be watched c befully. The various data sources now abide data even off on hebdomadal basis. The efforts be universe remunerative off and the market size of CDS has trim back considerably. And now with the central counterparties in pl ace the CDS market pass on score more transp bency and die control.After opening up of the thrift the beauteousness market of India form grown signifi brush asidetly bringing in more transp bency. But the corpo pass judgment d natural market is whitewash in un real mode and the efforts organism taken on developing it founder not provided expected returns. chthonian this light, India is now all set to de scarce Credit failure Swaps which argon expected to ignite the spark which leave alone flourish the corpo govern truss market. Considering the cautious nature of rbi and the havoc created by CDS in global market the move by RBI is signifi flockt. From the move of RBI one can think as the jab itself is not insidious entirely it depends whether its in doctors hand or a robbers hand. Similarly CDS as a product is certainly not harmful but its utility provide depend on the judicious use of the same.Chapter 2 Literature round offDerivativesThe global economic order that emerged after World War II was a corpse where m some(prenominal) less developed countries administered expenditures and centrally allocated resources. plain the developed economies ope evaluated under the Bretton Woods system of hardened convert pass judgment.The system of glacial impairments came under stress from the seventies onwards. High inflation and unemployment roves made post place more vapourific. The Bretton Woods system was level in 1971, freeing deputize come ins to fluctuate. Less developed countries equivalent India began opening up their economies and allowing prices to vary with market conditions.Price fluctuations made it hard for condescensiones to estimate their futurity production be and revenues. Derivative securities provide them with a valuable set of tools for managing this put on the line.Financial markets argon, by nature, extremely volatile and hence, the jeopardize factor is an Important concern for pecuniary agents. To deoxid ise this risk, the concept of derivatives comes into the picture. Derivatives ar products whose shelters argon derived from one or more basic variables called strands. These bases can be rudimentary assets (for example forex, virtue, etc), bases or reference measures.It is afinancial instrument(or more simply, an organization amid devil people/ dickens parties) that has a value primed(p) by the emerging price of something else. Derivatives can be thought of as bets on the price of something.Itis the collective prepargon utilize for a patient of class offinancial instrumentsthatderivetheir value from sepa tread financial instruments (known as the underlie), events or conditions. Essentially, a derivative is a slenderize between twain parties where the value of the write out is linked to the price of another financial instrument or by a specified event or condition.A protection whose price is dependent upon or derived fromone or more bloodlineamental assets.The d erivative itself is merely a contract between cardinal or more parties. Itsvalue is inflexibleby fluctuationsin the underlying asset.The nearly reciprocal underlying assets posit posts, bonds,commodities,currencies, post values and market indexes. Most derivatives be characterized by highschool leverage.Derivatives ar generally employ as an instrument to turn offrisk, but can withal be apply for unsound purposes.For example, wheat farmers whitethorn inclination to bewray their harvest at a future date to quench the risk of a change in prices by that date. The proceeding in this parapraxis would be the derivative, piece the cut price of wheat would be the underlying asset.Derivatives adopt probably been nearly for as prospicient as people have been duty with one another. Forward contracting dates back at least to the 12th century, and whitethorn well have been near before therefore. Merchants entered into contracts with one another for future delivery of specified occur of commodities at specified price. A base motivation for pre-arranging a bargainer or seller for a stock of commodities in first forrard contracts was to lessen the possibility that life-sized swings would mortify marketing the good after a harvest.The need for a derivatives marketThe derivatives market performs a heel of economic functionsThey help in transferring risks from risk averse people to risk oriented peopleThey help in the discovery of future as well as current pricesThey catalyse entrepreneurial activityThey increase the volume performanced in markets because of participation of risk averse people in greater numbersThey increase nest egg and enthronement funds funds in the gigantic runThe participants in a derivatives marketHedgers use futures or plectrons markets to reduce or eliminate the risk associated with price of an asset.Speculators use futures and pickaxes contracts to personate free leverage in betting on future movements in th e price of an asset. They can increase both the latent gains and potential drop losses by usage of derivatives in a speculative venture.Arbitrageurs ar in business to take advantage of a edition between prices in both distinguishable markets. If, for example, they see the futures price of an asset getting out of force with the coin in price, they exit take offsetting positions in the ii markets to lock in a profit.Types of DerivativesForwards A earlier contract is a customized contract between dickens entities, where settlement takes place on a particularised date in the future at todays pre-agreed price.Futures A futures contract is an harmony between ii parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of off contracts in the sense that the cause are standardized exchange-traded contractsOptions Options are of two types calls and puts. Calls give the emptor the refine but not the pledge to b uy a attached up criterion of the underlying asset, at a given price on or before a given future date. Puts give the purchaser the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.Warrants Options generally have lives of upto one year, the mass of creams traded on options exchanges having a maximum due date of nine months. Longer-dated options are called warrants and are generally traded otc.LEAPS The acronym LEAPS means Long-Term righteousness Anticipation Securities. These are options having a matureness of upto three years.Baskets Basket options are options on portfolios of underlying assets. The underlying asset is commonly a pitiable average or a basketful of assets. Equity index options are a form of basket options.Swaps Swaps are private agreements between two parties to exchange cash draws in the future gibe to a prearranged formula. They can be regarded as portfolios of forrard contrac ts. The two commonly used patronages are Interest rate exchanges These necessitate merchandiseping only the pursuance related cash flows between the parties in the same coin.Currency crafts These entail trade windping both nous and hobby between the parties, with the cash flows in one direction being in a divers(prenominal) currency than those in the opposite direction.Swaptions Swaptions are options to buy or sell a deal that go out obtain operative at the exhalation of the options. Thus a trade windtion is an option on a transport change. kinda than have calls and puts, the tacktions market has receiver swaptions and bearer swaptions. A receiver swaption is an option to receive dogged and compensation rootless. A payer swaption is an options to pay fix and receive blow.Uses of DerivativesDerivatives may be traded for a variety of debates. A derivative enables a trader to hedge some pre-existing risk by taking positions in derivatives markets that offset potential losses in the underlying or hint market. In India, most derivatives users describe themselves as hedgers (Fitch Ratings, 2004) and Indian integritys generally take aim that derivatives be used for hedging purposes only. Another reason for derivatives affair is surmisal (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to do it whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and in that locationby help to keep markets efficient. Jogani and Fernandes (2003) describe Indias long history in arbitrage traffic, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian beauteousness derivatives markets in 2 002 indicates that markets were inefficient at that time. They argue that lack of association market frictions and regulatory impediments have led to low levels of capital industrious in arbitrage work in India. However, more recent picture projects that the efficiency of Indian fair play derivatives markets may have improved (ISMR, 2004). increment of derivatives market in IndiaDerivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton throw Association started futures business in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the judicature criminalisened cash settlement and options traffic and derivatives occupation shifted to unceremonial before markets. In recent years, regularizement policy has changed, allowing for an change magnitude role for market-based pricing and less suspicion of derivatives work. The ban on futures concern of many c ommodities was lifted starting in the early 2000s, and national electronic trade good exchanges were created.In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was banned off and on till the Securities and Exchange get along with of India (SEBI) banned it for good in 2001. A serial of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial first appearances. NSE improved the efficiency and transparence of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a breastwork on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The distinguish of the L. C. Gupta direction, set up by SEBI, recommended a phased introduction of derivative products, and bi-level polity (i.e., self-regulation by exchanges with SEBI providing a supervisory and consultative role). Another report, by the J. R. Varma Committee in 1998, worked out various operable details such as the margining systems.The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on edge 17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recom mended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could as well as govern trading of securities. SEBI withal set up a crowd in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk control in derivatives market in India. The report, which was submitted in October 1998, worked out the available details of margining system, methodology for charging sign margins, broker net value, deposit urgency and real-time monitoring requirements. The Securities hug Regulation Act (SCRA) was amended in December 1999 to include derivatives in spite of appearance the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be heavy and valid only if such contracts are traded on a know stock exchange, thus precluding unlisted derivatives. The government also rescinded in ring 2000, the three- decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this progeny in May 2001. SEBI permitted the derivative shares of two stock exchanges, NSE and BSE, and their clearing field of operations/corporation to commence trading and settlement in approved derivatives contracts. To set about with, SEBI approved trading in index futures contracts based on SP CNX good and BSE-30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on single securities.The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on singular securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with SP CNX nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on ind ividual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on SP CNX job and settlement in derivative contracts is by dint of in accordance with the rules, byelaws, and regulations of the various(prenominal) exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (FO) Single-stock futures continue to account for a sizable proportion of the FO segment. It represent 70 per cent of the substance turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low unpredictability of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips.Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have change magnitude from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are progressively becoming pessimistic on the market.Farther month futures contracts are still not actively traded. avocation in equity options on most stocks for even the next month was non-existent.Daily option price variations suggest that traders use the FO segment as a less wild alternat ive (read substitute) to generate simoleons from the stock price movements. The fact that the option premiums tail intra-day stock prices is bear witness to this. Calls on Satyam fall, while puts rise when Satyam travel intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.SWAPIn finance, a SWAP is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. These streams are called the legs of the swap. conventionally they are the exchange of one security for another to change the maturity date (bonds), quality of issues (stocks or bonds), or because investing objectives have changed.A swap is an agreement to exchange one stream of cash flows for another. Swaps are most usually used to-Switch funding in one sphere for financing in anotherTo put back a travel involution rate swap with a fixed come to rate (or infirmity versa)(Litzenberger, R.H)In August 1981 the World Bank issued $290 one million million in euro-bonds and swapped the interest and star topology on these bonds with IBM for Swiss francs and German marks. The quick growth in the use of interest rate swaps, currency swaps, and swaptions (options on swaps) has been phenomenal. Currently, the amount of outstanding interest rate and currency swaps is almost $3 zillion.Recently, swaps have grown to include currency swaps and interest rate swaps. It can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.If firms in come apart countries have relative advantages on interest rates, so a swap could benefit both firms. For example, one firm may have a visit fixed interest rate, while another has access to a tear down floating interest rate. These firms could swap to take advantage of the lower rates.Different types of swaps-Currency SwapsCr oss currency swaps are agreements between counterparties to exchange interest and principal payments in different currencies. Like a forward, a cross currency swap consists of the exchange of principal amounts (based on todays spot rate) and interest payments between counterparties. It is considered to be a abroad exchange transaction and is not required by law to be shown on the equilibrize sheet.In a currency swap, these streams of cash flows consist of a stream of interest and principal payments in one currency interchange for a stream, of interest and principal payments of the same maturity in another currency. Because of the exchange and re-exchange of imaginary principal amounts, the currency swap generates a larger credit exposure than the interest rate swap.Cross-currency swaps can be used to modify the currency denomination of assets and liabilities. They are impelling tools for managing foreign currency risk. They can create currency match at heart its portfolio and minimize exposures. Firms can use them to hedge foreign currency debts and foreign net investments.Currency swaps give companies extra flexibility to travail their relative advantage in their several(prenominal) acceptation markets. Currency swaps allow companies to exploit advantages across a hyaloplasm of currencies and maturities.Currency swaps were originally done to get around exchange controls and hedge the risk on currency rate movements. It also helps in step-down costs and risks associated with currency exchange.They are ofttimes combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is peculiarly common in Europe where companies haunt for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in fate currency.Credit Default SwapCredit Default Swap is a financial instrument for swapping the risk of debt disrespect. Credit default swaps may be used for emerging market bonds, mortgage backed securities, collective bonds and local government bond.The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump juncture payment if the debt instrument is defaulted.The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.The first credit default swap was introduced in 1995 by JP Morgan. By 2007, their essence value has increased to an estimated $45 trillion to $62 trillion. Although since only 0.2% of investment Companys default, the cash flow is much lower than this actual amount. consequently, this shows that credit default swaps are being used for speculation and not insuring against actual bonds.As Warren Buffett calls them financial weapons of mass destruction. The credit default swap s are being blamed for much of the current market meltdown.Example of Credit Default SwapAn investment trust owns 1 million corporation bond issued by a private trapping firm.If there is a risk the private lodging firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth 1 million.The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of 30,000 a year for the duration of the contract.If the private living accommodations firm doesnt default. The hedge fund gains the interest from the investment chamfer and pays nothing out. It is simple profit.If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of 1 million the value of the credit default swap.Therefore the hedge fund takes on a larger risk and could end up paying 1millionThe higher the sensed risk of the bond, the higher the interest rate the hedge fund will require.Credit d efault swaps are used not only by investment banks, but also by other financial institutions. corporal entities use credit default swaps either for protection purposes, to hedge or to sell. Investment banks are primarily affected by the buyers. If a number of major corporate entities have bought protection from the same investment bank, and all of them fail simultaneously, this will put pressure on the investment bank to pay out. Moreover, the credit risk caused by the above failure may lead to other risks, such as liquidity risk, market risk and operational risk. Therefore, most of the investment banks re-sell the sell protection on the market to other market participants. Edwards (2004) argues that derivatives do not reduce credit risk, but rather transfer it from banks to other banks or entities. Therefore, most of the investment banks re-sell the sold protection on the market to other market participants. Edwards (2004) argues that derivatives do not reduce credit risk, but rat her transfer it from banks to other banks or entities. rough of the top banks in America are carrying unknown sport risks that no one has warned about, and they are all tied up in U.S. bank derivative portfolios (Edwards M, 2004). goodness SwapA good swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The spacious majority of commodity swaps involve oil. A swap where exchanged cash flows are dependent on the price of an underlying commodity. This swap is usually used to hedge against the price of a commodity. Commodities are physical assets such as precious metals, base metals, pushing stores (such as natural gasconade or crude oil) and food (including wheat, pork bellies, cattle, etc.).In this swap, the user of a commodity would secure a maximum price and agree to pay a financial institution this fixed price. Then in return, the user would get payments based on the market price for the commodity involved.The y are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices.A company that uses commodities as input may take in its profits becoming very volatile if the commodity prices become volatile. This is peculiarly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. There are two kinds of agents participating in the commodity markets end-users (hedgers) and investors (speculators).Commodity swaps are becoming progressively common in the energy and agricultural industries, where demand and supply are both subject to considerable uncertainty. For example, heavy users of oil, such as air ducts, will often enter into contracts in which they agree to make a series of fixed payments, say every six months for two years, and receive payments on those same dates as determined by an oil price index. Computations are often based on a specific number of rafts of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the biyearly period. However, the airline will typically buy the actual oil it needs from the spot market.Equity SwapThe outstanding performance of equity markets in the 1980s and the 1990s, have brought in some technological innovations that have made widespread participation in the equity market more feasible and more marketable and the demographic imperative of baby-boomer saving has generated significant interest in equity derivatives. In addition to the listed equity options on individual stocks and individual indices, a burgeoning over-the-counter (OTC) market has evolved in the distribution and utilization of equity swaps.An equity swap is a special type of replete(p) return swap, where the underlying asset is a stock, a basket of stocks, o r a stock index. An exchange of the potential appreciation of equitys value and dividends for a guaranteed return plus any decrease in the value of the equity. An equity swap permits an equity toter a guaranteed return but demands the bearer give up all rights to appreciation and dividend income. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.Equity swaps make the index trading strategy even easier. Besides diversification and appraise income benefits, equity swaps also allow large institutions to hedge specific assets or positions in their portfoliosThe equity swap is the take up swap amongst all the other swaps as it being an over-the-counter derivatives transaction they have the attractive blow of being customizable for a particular users situation. Investors may have specific time horizons, portfolio compositions, or other terms and conditions that are not matched by exchange-listed derivatives. They are private transactions that are not directly reportable to any regulatory authority.A derivatives dealer can, through a foreign adjunct in the particular country, invest in the foreign securities without the withholding tax and enter into a swap with the resurrect dealer company, which can then enter a swap with the American investor, effectively passing on the dividends without the withholding taxInterest rank SwapAn interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a sequence of interest payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promises to pay to the routine at designated intervals a stipulated amount of interest calculated at a fixed rate on the notional principal the second party promises to pay to the first at the same intervals a floating amount of interest on the notional principle calculated according to a floating-rate i ndex.The interest rate swap is essentially a loot of forward contracts exchanging interest payments. Thus, interest rate swaps, like interest rate futures or interest rate forward contracts, offer a machine for restructuring cash flows and, if properly used, provide a financial instrument for hedging against interest rate riskThe reason for the exchange of the interest obligation is to take benefit from comparative degree advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floatImpact of Credit Default Swaps (CDS)Impact of Credit Default Swaps (CDS)Chapt er 1 IntroductionA Swap is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. Swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral. It can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.The main objective of the project is to understand about Credit Default Swaps (CDS), its global footprint, its role in subprime crisis, its settlement in global arena and to check the feasible settlement of CDS in India, after its introduction in India, by understanding about Indian Credit Derivatives market. Research is concerned with the systematic and objective collection, analysis and evaluation of information about specific aspects to check the feasible settlement of CDSs in India.The development of fi nancial derivatives in recent past is astounding when we consider its volume globally. But at the same time the product once created for hedging the risk currently allows you to bear more risk sometimes making the whole financial system to tremble. May be thats why Warren Buffet called it a financial weapon of mass destruction. Whatever it may be but derivatives have grown exponentially and are necessary for the market to flourish.The credit derivatives are nothing but the logical extension to the family of derivatives and have already made its presence felt globally. The credit derivatives have played a significant role in the development of debt market but also share a blame for the proliferation of subprime crisis.A credit default swap which constitutes the major portion of credit derivatives is similar to an insurance contract which allows you to transfer your risk to third party in exchange of a premium. Right from its origin as plain vanilla product for hedging purpose it has grown to very complex products and now has posed a question mark on its credibility.The subprime crisis started in what were regarded as the worlds safest and most sophisticated markets and spread globally, carried by securities and derivatives that were thought to make the financial system safer. The subprime crisis brings the complexity of securitized products and derivatives products, the human greedy nature, inability of rating agencies to gauge the risk, inefficiency of regulatory bodies, etc. to the fore. Although CDS was not the cause of the subprime crisis but it had cascading effect on the market and was considered as the reason for the collapse of American International Group (AIG).The lessons from the consequences of subprime crisis have helped in creating awareness about the regulatory frameworks to be in place which has increased the transparency, standardization, and soundness in the market. The various measures include formation of central counterparty for CDS, hardwi ring of auction protocol and ISDA determination committee. On the backdrop of global crisis the movement of CDS is being watched carefully. The various data sources now provide data even on weekly basis. The efforts are being paid off and the market size of CDS has reduced considerably. And now with the central counterparties in place the CDS market will have more transparency and better control.After opening up of the economy the equity market of India have grown significantly bringing in more transparency. But the corporate bond market is still in undeveloped mode and the efforts being taken on developing it have not provided expected returns. Under this light, India is now all set to launch Credit Default Swaps which are expected to ignite the spark which will flourish the corporate bond market. Considering the cautious nature of RBI and the havoc created by CDS in global market the move by RBI is significant. From the move of RBI one can say as the knife itself is not harmful bu t it depends whether its in doctors hand or a robbers hand. Similarly CDS as a product is certainly not harmful but its utility will depend on the judicious use of the same.Chapter 2 Literature ReviewDerivativesThe global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates.The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions.Price fluctuations made it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them with a valuable set of tools for managing thi s risk.Financial markets are, by nature, extremely volatile and hence, the risk factor is an Important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates.It is afinancial instrument(or more simply, an agreement between two people/two parties) that has a value determined by the future price of something else. Derivatives can be thought of as bets on the price of something.Itis the collective name used for a broad class offinancial instrumentsthatderivetheir value from other financial instruments (known as the underlying), events or conditions. Essentially, a derivative is a contract between two parties where the value of the contract is linked to the price of another financial instrument or by a specified event or condition.Asecurity whose pric e is dependent upon or derived fromone or more underlying assets.The derivative itself is merely a contract between two or more parties. Itsvalue is determinedby fluctuationsin the underlying asset.The most common underlying assets includestocks, bonds,commodities,currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.Derivatives are generally used as an instrument to hedgerisk, but can also be used forspeculative purposes.For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset.Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specif ied amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.The need for a derivatives marketThe derivatives market performs a number of economic functionsThey help in transferring risks from risk averse people to risk oriented peopleThey help in the discovery of future as well as current pricesThey catalyze entrepreneurial activityThey increase the volume traded in markets because of participation of risk averse people in greater numbersThey increase savings and investment in the long runThe participants in a derivatives marketHedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potenti al gains and potential losses by usage of derivatives in a speculative venture.Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.Types of DerivativesForwards A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price.Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contractsOptions Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.Warrants Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.LEAPS The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.Baskets Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.Swaps Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are Interest rate swaps These entail swapping only the interest relate d cash flows between the parties in the same currency.Currency swaps These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.Swaptions Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an options to pay fixed and receive floating.Uses of DerivativesDerivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some pre-existing risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (Fitch Ratings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe Indias long history in arbitrage trading, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time. They argue that lack of knowledge market frictions and regulatory impediments have led to low levels of capital employed in arbitrage trading in India. However, more recent evidence suggests that the efficiency of Indian equity derivatives markets may have improved (ISMR, 2004).Development of derivatives market in IndiaDerivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created.In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee i n 1998, worked out various operational details such as the margining systems.The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures f or risk control in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three- decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/co rporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on SP CNX Nifty and BSE-30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with SP CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on SP CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (FO) Single-stock futures continue to account for a sizable proportion of the FO segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recom mending index options to their clients, because low volatility leads to higher waiting time for round-trips.Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.Daily option price variations suggest that traders use the FO segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not hav e a one-to-one impact on the option premiums.SWAPIn finance, a SWAP is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. These streams are called the legs of the swap. Conventionally they are the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed.A swap is an agreement to exchange one stream of cash flows for another. Swaps are most usually used to-Switch financing in one country for financing in anotherTo replace a floating interest rate swap with a fixed interest rate (or vice versa)(Litzenberger, R.H)In August 1981 the World Bank issued $290 million in euro-bonds and swapped the interest and principal on these bonds with IBM for Swiss francs and German marks. The rapid growth in the use of interest rate swaps, currency swaps, and swaptions (options on swaps) has been phenomenal. Currently, the amount of outstanding interest rate and currency swaps is almost $3 trillion.Recently, swaps have grown to include currency swaps and interest rate swaps. It can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.Different types of swaps-Currency SwapsCross currency swaps are agreements between counterparties to exchange interest and principal payments in different currencies. Like a forward, a cross currency swap consists of the exchange of principal amounts (based on todays spot rate) and interest payments between counterparties. It is considered to be a foreign exchange transaction and is not required by law to be shown on the balance shee t.In a currency swap, these streams of cash flows consist of a stream of interest and principal payments in one currency exchanged for a stream, of interest and principal payments of the same maturity in another currency. Because of the exchange and re-exchange of notional principal amounts, the currency swap generates a larger credit exposure than the interest rate swap.Cross-currency swaps can be used to transform the currency denomination of assets and liabilities. They are effective tools for managing foreign currency risk. They can create currency match within its portfolio and minimize exposures. Firms can use them to hedge foreign currency debts and foreign net investments.Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets. Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities.Currency swaps were originally done to get around exchange controls and hedge the ri sk on currency rate movements. It also helps in Reducing costs and risks associated with currency exchange.They are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies shop for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.Credit Default SwapCredit Default Swap is a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond.The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted.The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.The first credit default swap was introduced in 1995 by JP Morgan. By 2007, their total value has increased to an estimated $45 trillion to $62 trillion. Although since only 0.2% of Investment Companys default, the cash flow is much lower than this actual amount. Therefore, this shows that credit default swaps are being used for speculation and not insuring against actual bonds.As Warren Buffett calls them financial weapons of mass destruction. The credit default swaps are being blamed for much of the current market meltdown.Example of Credit Default SwapAn investment trust owns 1 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 hedge fund. The CDS is worth 1 million.The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of 30,000 a year fo r the duration of the contract.If the private housing firm doesnt default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of 1 million the value of the credit default swap.Therefore the hedge fund takes on a larger risk and could end up paying 1millionThe higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.Credit default swaps are used not only by investment banks, but also by other financial institutions. Corporate entities use credit default swaps either for protection purposes, to hedge or to sell. Investment banks are primarily affected by the buyers. If a number of major corporate entities have bought protection from the same investment bank, and all of them fail simultaneously, this will put pressure on the investment bank to pay out. Moreover, the credit risk caused by th e above failure may lead to other risks, such as liquidity risk, market risk and operational risk. Therefore, most of the investment banks re-sell the sold protection on the market to other market participants. Edwards (2004) argues that derivatives do not reduce credit risk, but rather transfer it from banks to other banks or entities. Therefore, most of the investment banks re-sell the sold protection on the market to other market participants. Edwards (2004) argues that derivatives do not reduce credit risk, but rather transfer it from banks to other banks or entities. Some of the top banks in America are carrying unknown gambling risks that no one has warned about, and they are all tied up in U.S. bank derivative portfolios (Edwards M, 2004).Commodity SwapA commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve oil. A swap where exchanged cash flows are depen dent on the price of an underlying commodity. This swap is usually used to hedge against the price of a commodity. Commodities are physical assets such as precious metals, base metals, energy stores (such as natural gas or crude oil) and food (including wheat, pork bellies, cattle, etc.).In this swap, the user of a commodity would secure a maximum price and agree to pay a financial institution this fixed price. Then in return, the user would get payments based on the market price for the commodity involved.They are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices.A company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and p ays a fixed rate in exchange. There are two kinds of agents participating in the commodity markets end-users (hedgers) and investors (speculators).Commodity swaps are becoming increasingly common in the energy and agricultural industries, where demand and supply are both subject to considerable uncertainty. For example, heavy users of oil, such as airlines, will often enter into contracts in which they agree to make a series of fixed payments, say every six months for two years, and receive payments on those same dates as determined by an oil price index. Computations are often based on a specific number of tons of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the two-year period. However, the airline will typically buy the actual oil it needs from the spot market.Equity SwapThe outstanding performance of equity markets in the 1980s and the 1990s, have brought in some technological innovations that have made wi despread participation in the equity market more feasible and more marketable and the demographic imperative of baby-boomer saving has generated significant interest in equity derivatives. In addition to the listed equity options on individual stocks and individual indices, a burgeoning over-the-counter (OTC) market has evolved in the distribution and utilization of equity swaps.An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. An exchange of the potential appreciation of equitys value and dividends for a guaranteed return plus any decrease in the value of the equity. An equity swap permits an equity holder a guaranteed return but demands the holder give up all rights to appreciation and dividend income. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.Equity swaps make the index tradi ng strategy even easier. Besides diversification and tax benefits, equity swaps also allow large institutions to hedge specific assets or positions in their portfoliosThe equity swap is the best swap amongst all the other swaps as it being an over-the-counter derivatives transaction they have the attractive feature of being customizable for a particular users situation. Investors may have specific time horizons, portfolio compositions, or other terms and conditions that are not matched by exchange-listed derivatives. They are private transactions that are not directly reportable to any regulatory authority.A derivatives dealer can, through a foreign subsidiary in the particular country, invest in the foreign securities without the withholding tax and enter into a swap with the parent dealer company, which can then enter a swap with the American investor, effectively passing on the dividends without the withholding taxInterest Rate SwapAn interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a sequence of interest payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promises to pay to the second at designated intervals a stipulated amount of interest calculated at a fixed rate on the notional principal the second party promises to pay to the first at the same intervals a floating amount of interest on the notional principle calculated according to a floating-rate index.The interest rate swap is essentially a strip of forward contracts exchanging interest payments. Thus, interest rate swaps, like interest rate futures or interest rate forward contracts, offer a mechanism for restructuring cash flows and, if properly used, provide a financial instrument for hedging against interest rate riskThe reason for the exchange of the interest obligation is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other compani es have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a float