Introduction of credit derivatives in India

Abstract

We in this report have tried to study the impact of CDS trading on the bond markets in Asia. On the basis of our findings, we were able to find out some of the benefits and drawbacks of introduction of CDS in the bond markets of India. Through our research we have been able to conclude the following: ? CDS trading has lowered the cost of issuing bonds ? CDS trading has increased the liquidity in the bond market. ? These positive impacts are stronger for smaller firms and non-financial firms. ? CDS trading has also introduced a new source of risk. We have also found strong evidence that, at the peak of the recent global financial crisis, those firms included in CDS indices faced higher bond yield spreads than those that were not included. The introduction, growth and failures of the credit derivatives market have been one of the very important developments in the global credit market in the past few years. Before the onset of the global financial turmoil that started in mid-2007, the use of credit default swaps (CDS's) as an instrument to trade credit risk had increased enormously. After 2008 the CDS market as such has reduced substantially. If we look at, the CDS market has also grown rapidly over the past few years, despite the fact that it is relatively small and illiquid compared the CDS markets in Europe and the United States. CDS contracts written on Asian reference entities started to be traded in the late 1990s. The CDS market in Asia began to emerge as a different market altogether. Unlike in Europe and the United States, the CDS market in Asia was introduced when the corporate bond market was in its early phase of development. In most of the Asian markets, the size of the bond market was quite small, the trading was not liquid, and the issuance of new bonds was largely driven by semi-government issuers or issuers with some form of credit guarantees. Since the onset of 2000, the characteristics of the Asian bond market have improved greatly, due to 2 reasons: ? The attempt of Asian policymakers to develop the local bond markets ? The positive spill over between the bond market and the derivatives market We in this report have tried to study the impact of the development of the CDS market on the corporate bond market. For this we have focused on the bond market and examined whether the bond market development, for instance the cost of issuing and trading bonds, is affected by the introduction of CDS markets. The impact of CDS in the US markets is different from that of the Asian markets. The possible causes may be as follows: ? The different stages of development in the Asian and US bond markets when CDS's were introduced. Since the bond markets in many Asian economies were underdeveloped from the beginning, it is more likely that CDS trading will have a jump-start effect on the Asian bond markets. ? The second reason can be that the investors in Asian bond markets are mostly domestic investors, while those in the US CDS markets are mostly foreign investors. The different sets of investors in these 2 markets are likely to be an important factor in causing the differential impacts in these 2 markets. We, in this report have presented the connection between the bond and CDS markets in Asia during the period from January 2002 to December 2010. We have divided our research into 3 main divisions: ? What is the impact of CDS trading on the Asian bond market in terms of the bond issuance cost and the liquidity in the market? ? Which category of bond issuers is most likely to benefit from the introduction of CDS? ? How did the impact of CDS trading on the bond market vary during the global financial crisis? The main findings are as follows: ? Our results support that CDS trading is associated with lower cost and higher liquidity for new bond issuance in Asia. This result is similar to the results found in the corresponding US bond markets. ? We find that the positive impact of CDS trading on the bond market tends to be stronger for smaller firms and non-financial firms. Also, in cost and liquidity terms, he firms with higher liquidity in the CDS market enjoys a greater benefit in the primary bond market. ? We also concluded that the impact of CDS trading on the bond market is different from normal during the crisis period. Our data sample tells us how the bonds having CDS were impacted differently during the crisis. Our analysis shows that, at the peak of the global financial crisis, those firms included in CDS indices had to face higher spreads than those that were not included in the CDS indices, leaving apart the general increase in the credit spreads in the bond market during the crisis. This means that CDS trading has its own negatives and it can introduce new sources of shocks and risks to the corresponding bond market.