21st November 2006 By Rahul Mehta (0511112) Vineet Kumar Gupta (0511054)

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Scope, Structuring and Pricing of Credit Derivatives in India

Contemporary Concerns Study

Under the Guidance of

Prof. P.C. Narayan
Submitted on

21st November 2006
Rahul Mehta (0511112)
Vineet Kumar Gupta (0511054)

table of contents

table of contents 3

executive summary 4

introduction – credit derivatives 6


Indian scenario 12

products introduced in india 17

comparison with other markets 21

the way ahead 25

implied pricing of credit protection 28

observations 35

implications and conclusions 38

exhibits 40

references 43

executive summary

The Indian growth story has been doing the rounds for quite a while now. It takes more than luck to transform from being perceived as a country of snake charmers and bullock carts to a preferred investment frontier with its equity markets giving far better returns than most of the developed economies. It is very surprising to note that a country with a projected growth rate of 8-10 % has had very insignificant development in financial instruments like credit derivatives.

Through this project we have analyzed the evolution and growth of the credit derivatives market globally and then moved on to analyze the needs and obstacles for the introduction of credit derivatives in India. We realized through our study that the biggest hindrance for the development of the credit derivatives market in India is the non-existence of a liquid and vibrant bond market. For gaining a better perspective of the steps that should be taken to clear this major roadblock, we have analyzed the South Korean bond market and have noticed the important catalytic role that the government needs to play for developing the Indian bond markets. In light of these analyses, we discuss what needs to be done for the debt market to be a significant growth contributor. It is then contemplated that in spite of the imperfections in the market, what would be the right spread at which credit protection on a reference entity would sell as perceived by the market. The implied term structure of default intensity of the bond is estimated using the bond prices, which is used to estimate the inherent Credit Default Swap spread. A few reasonably liquid bonds were selected from the wholesale debt market and this analysis was performed. The implied credit spreads seem to be following the same pattern as the bond yields and are highly correlated with the yields. Also, the bond yields and spreads seem to indicate that the market sees the credit environment to be less volatile in the near term.

We discovered in our study that many problems that the Indian corporate bond market faces today are self causal in nature and feed on themselves. Most important of these are: a small issuer base, limited investor base, and an under-developed derivatives market (especially securitization). The government needs to wake up to the fact that it cannot rely on the equities market alone to drive the growth that it sees coming in the future.

It is crucial to encourage more participation both from the issuing as well as investing sides through innovative methods like duty restructuring, tax breaks and improving the regulatory environment. The government has to extend a mentoring hand to the market by acting as counterparty to complex transactions for nurturing the belief of growth and stability from this market.
Once the fundamental road blocks are out of the way, the markets will gain liquidity, which will attract a lot of market makers, arbitrageurs, speculators and other participants to the market; this will spiral the liquidity further. Volumes will start picking up and with a little support a regulator like SEBI, a smooth inflow and outflow of investments will be facilitated. As the knowledge about the market fundamentals grows, the retail investor may become an important contributor to the market, just like what is happening to the Indian equity markets today.
So, in essence what needs to be done is to reverse all the self causing reasons for the under-development of the corporate debt markets and then make them into self feeding reasons for the establishment of efficient debt markets, which would then pave the way for introduction of credit derivatives in India.

introduction – credit derivatives

The primary purpose of credit derivatives is to facilitate the efficient transfer and repackaging of credit risk. Credit derivatives markets have evolved at an extremely rapid pace since their inception. The notional market size has grown from $40 billion in 1996 to $740 billion in 2000 and $4.8 trillion in 2004.

The first credit derivatives were traded in the late 1980s, when the first cash flow CDOs were issued. These were often in the form of swaps on specific bonds created for tax or regulatory purposes. In the 1990s, credit derivatives came to be used in the synthetic form wherein large balance sheet synthetic CDOs were issued for regulatory capital relief. Banks typically bought protection on the large portfolio of loans sitting on them. Basel I norms also put a thrust on the use of credit derivatives by requiring banks to keep aside more capital against the risky loans in their portfolio. Banks were also very keen to transfer the risk to entities which were not subject to such stringent adequacy requirements. In 1996, ISDA published the first definitions of credit derivative instruments and revised them in 1999 for greater level of standardization and acceptance.

In terms of market events, 2001 was the most eventful year for the evolution of this market when Enron defaulted on its loans; this was the biggest corporate default by the volume of debt outstanding. The Enron default was followed by the default by Argentina, which was the biggest sovereign default by the volume of debt. These events led to a lot of activity in the industry and led to widespread recognition of credit instruments and made the need for these instruments felt. In 2003, the concept of credit indices started emerging wherein indices like CDX and iTraxx were developed on the basis of liquid credit names to assess the overall trends and nature of the credit markets.
The most popular credit instruments are credit default swaps. Fig 1 shows the tremendous pace at which this market has grown over the past few years. Over time a huge variety of structured credit instruments have evolved as a result of innovative financial engineering and the OTC nature of the market. Fig 2 summarizes the reasons for the use of credit instruments by different participants in the market.

Fig 1: Growth of notional principal in the CDS market (in USD trillion) (Source: International Swaps and Derivatives Association)

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