RIIB Topic: Credit Derivatives

GROUP MEMBERS Chirag Ranka129 Raj Jain128 Shekhar Mehta107 Prathamesh Thakar118 Vijeta Sharma 109 Vinayak Sukhatme123

Credit derivative What is credit? 1.Lender 2.Borrower 3.Role of bank- extended credit

derivative Underlying value of an asset Forward contracts Futures contracts Option swaps

Options gives the buyer the right not the obligation to buy or sell a specified underlying at a set price on or before a specified date

FuturesOptions Exchange TradedSame as futures Exchange defines the productSame as futures Price is zero, Strike price (futures price) moves Strike price is fixed, Price moves Price is zeroPrice is always positive Linear PayoffNon Linear Payoff Both long and short are at riskOnly short at risk Difference Between Futures and Options

Options RIGHTS with the Buyer OBLIGATION : SELLER The Buyer EXERCISES his Rights to buy or sell an asset in future. The Buyer purchases is a RIGHT from the Seller The Seller meets his OBLIGATIONS to sell or buy the asset in future

3 types of interest 1.Subsidized interest 2. Free market interest 3.Other types such as Cost of fund interest (PLR) Based Rate Bench Marked Rate Libor Rate

Concept of bad loans Depends on Trust of Depositor and investors Financial system is based on trust. NPA. E.g. American Financial System

Products offered in credit derivatives (CLN) Credit Linked note It’s a promissory note and it is negotiable. A combination of a regular note (bond or deposit) and a credit-option. Created through a SPV. Can be issued by any bank, financial institution or NBFC.

CLN Issued by ICICI – Subscribed by UCO Bank The structure involves 150 Cr. loan portfolio of ICICI Bank through an SPV. The CLNs would be issued in 3 tranches - classes A, B and C. –Class A - CLN rated AAA issue size 80 Cr. –Class B - CLN rated AA issue size 65 Cr. –Class C - First loss position of 5 Cr.

CLN Issued by ICICI – Subscribed by UCO Bank Benefits to ICICI Bank –Can reduce exposure/ concentration on the particular corporate / industrial sector to which bank is overexposed. –Regulatory capital relief - The risk weighted exposure is reduced by the amount of funding received. The extent of assets collateralized by government securities is assigned a 0% risk weightage. First loss provision of 5 Cr. would attract a capital requirement with 100 % risk weight.

CLN Issued by ICICI – Subscribed by UCO Bank –Pre-transaction regulatory capital requirement for ICICI would be CAR * risk weighted assets i.e. 9% x 100 % x 150 which is 13.5 Cr. –Post-transaction capital requirement will reduce to provision for first loss piece as the class A and B are fully funded and hence attract 0 % risk weight, i.e. 5 Cr. Thus, there is regulatory capital relief of 8.5 Cr. Benefits to UCO –Can get synthetic exposure on good credits –Sectoral diversification

Credit Default Swaps (CDS) Premium is loaded in loan price itself. Protecting the loan by giving guarantees in case it is defaulted. Introduced in early 1990’s. Effective tool for hedging. E.g. London banks giving loan of $ 4bn to TATA.

Credit Default Swap A buyer (A) pays a premium (single or periodic payments) to a seller (B) but if a credit event occurs the seller (B) will compensate the buyer. Reference asset premium Contingent payment

Types of CDS Binary swap Basket CDS Cancelable default swap (callable CDS or putable CDS) Contingent CDS Leveraged CDS

Types of CDS  Binary swap Pre-default valuation Fixed amount  Basket CDS Multi-name reference Suited to protection buyers who have a better expectation about default frequencies

 Cancelable default swap Callable CDS Putable CDS  Contingent CDS contingent event; e.g. default on another credit.

Collateralized Debt Obligations (CDO) Mortgage linked product E.g. AIG bailout. 1.Asset liability mismatch 2.Create liquidity in balance sheet

Types of CDO’s A) Based on the underlying asset: Collateralized loan obligations (CLOs) Collateralized bond obligations (CBOs) Collateralized synthetic obligations (CSOs) Structured finance CDOs (SFCDOs) B) Other types of CDOs Commercial Real Estate CDOs (CRE CDOs) Collateralized bond obligations (CBOs) Collateralized Insurance Obligations (CIOs) CDO-Squared

Example of USA Mortgage failure Non eligible people got loan No income /cannot pay Ninja Hence….resulted into Subprime crisis.

Interest rate swaps Only interest rate swaps Only principal rate swaps Currency swaps Principle only Swap (POS) Principle Interest Swap (PIS)

(Forward Rate Agreement) FRA

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