Analysis of credit derivatives products and its market potential in India

Abstract

The rise of the credit derivative market has been one of the most important developments in fixed income and has revolutionized the transfer of credit risk. In the OTC Derivatives market, the Credit Derivatives are fastest growing segment today. The growth is coming due to the advantages credit derivatives has over the cash alternative along with new possibilities it brings to both hedgers and investors, who are seeking new ways to take on exposure to credit along with diversification and yield enhancements. Worldwide, notional amount outstanding of credit derivatives grew by 32% in the first six months of the 2007 to $45.46 trillion from $34.42 trillion at December 31, 2006. The annual growth rate for credit derivatives is 75% from $26.0 trillion at mid-year 2006. Credit Default Swaps (CDS) on single-names, baskets and portfolios of credits and index trades grew at 101 percent for the whole of calendar year 2006, compared with 103percent during year calendar 2005. (Source: ISDA)However, market size is only part of the story product innovation has also been significant. From the basis of an expanding universe of quoted credit default swaps (CDS) sprang a diverse range of structured credit products. First-To-Default baskets (FTDs) and synthetic CDOs have become familiar products, offering enhanced yields and tailored risk-return profiles. CDS basket indices, such as TRAC-X, provide liquidity in trading transparent portfolios of benchmark credits. Built on this liquidity, trading of TRAC-X tranches has initiated a two-way market in correlation, which is a key driver of credit portfolio performance. CDS options, either on credit indices or on individual names, are also gaining popularity or allow investors to express views on spread volatility. In the Understanding Credit Derivatives series, we will cover products ranging from single-name CDS and Credit-Linked Notes (CLNs), to correlation products such as FTDs and synthetic CDOs, to volatility products such as CDS options. For each product type, we will discuss the structure, valuation techniques, risks and performance drivers. In this project we have used case study of Bank to describe various credit derivatives products and issues involved with each of them. Further to this study we are extending this to Indian Context describing the current market potential and the need and benefit of such products to various participants. The analysis of the regulatory framework put forward by Reserve Bank of India, draft version of guidelines on Credit Derivatives (Credit Default Swaps), and its implication to the market and its participants. In the backdrop of recent developments in world market, the sub-prime crisis, we have tried to list out key issues, concerns and challenges going ahead, especially relevant to Indian Context.