Credit derivatives will be introduced from November, 2011 in India in the form of plain vanilla single name credit default swaps (‘CDS’) for corporate bonds.
What are Credit Derivatives?
Credit derivatives isolate and separate credit risk from market risk, allowing credit risk to be hedged, traded or transferred. They efficiently distribute credit risk across the market; help institutions meet risk management objectives and preserve customer relationships whilst complying with regulations/laws (e.g. capital adequacy requirements). The most common product is a CDS.
In a CDS, a protection buyer pays a protection seller a regular premium (similar to an insurance premium) in order to transfer exposure to a reference entity’s credit risk. If a contractually defined credit event occurs, affecting the reference entity, the protection seller makes a contingent payment to the protection buyer.
Controversy surrounding Credit Derivatives
Over the last decade or so, certain financial products and markets have been embroiled in controversy. Complex structured products like collateralised debt obligations (‘CDOs’) have made credit risk assessment much more difficult. Further, as secondary markets have developed, protection sellers have gained more bargaining power, and trading has become more speculative, unlike the original products where end users were genuinely hedging against credit risk of counterparties. Consequently, moral hazard increased as can be seen in the key roles these products played in the US sub-prime mortgage crisis, the collapse of Lehman Bros and the fact that they have been linked by some with the Greek sovereign debt crisis.
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[The author is an Associate, Corporate Division, Lakshmi Kumaran & Sridharan, New Delhi]