Scope, structuring and pricing of credit derivatives in India

Abstract

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 nonexistence 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.