In my earlier blog I had written about a derivative instrument called the credit default swap. The ET on 28th June 2007 carried an article about how banks are offering equity linked notes to woo rich investors. This is a clear indicator of how our markets are maturing in a big way.

Citibank and DSP Merrill Lynch have issued equity linked notes to raise resources. The equity linked notes are basically debt instruments issued at a discount with certain additional payoffs being made on the happening or non happening of certain events. To cite an example A Ltd can issue a debenture at Rs.100 which will be repayable on maturity at 100+3 = Rs.103. It can however contain a rider which says that if the Nifty falls / rises by more than say 30% any time between the date of allotment and the date of redemption the repayment will be say Principal + 20%.

This kind of a product provides capital safety plus the opportunity to participate in a equity rally by the investor, while for the borrower it may enable him to issue such paper at a lesser rate than what he would had to offer on a pure debt instrument. These bonds will be rated and traded on the NSE. However as of right now due to lack of depth and knowledge of the product it is likely to be a OTC product with limited liquidity. However if a number of company (say the index companies) start coming out with such an instrument then it will be quite possible to create a basket derivative of such instruments.

This also means that credit rating agencies in India which have so far been rating predominantly vanilla products will have to gear themselves up to deal with such sophisticated instruments. Like I keep saying - exciting times ahead!!!!!!!!

DERIVATIVES -
AN INTRODUCTION TO CREDIT DEFAULT SWAP

Credit default swap: Two parties enter into an agreement whereby one party pays the other a fixed periodic coupon for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and the swap then terminates.

Another way of putting it:
The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.

Use of CDS by commercial banks
Commercial banks use credit default swaps to manage the credit risk associated with making large loans to their corporate customers. If a borrower defaults on a loan or another predefined credit event occurs, the counterparty providing the insurance purchases the defaulted asset.

Credit default swaps are a very common form of Credit Derivative. The objective in many credit derivatives, including default swaps, is to split market risk from credit risk; doing so effectively reduces a bank's exposure and its risk of loss.

A CDS is often used like an insurance policy, or hedge for the holder of debt . The typical term of a CDS contract is five years, although being an OTC product almost any maturity is possible.

An Example A fund has invested Rs 10 croreds worth of a 5 year bond issued by Risky Corporation. In order to manage their risk of losing money if Risky Corporation defaults on its debt, the fund buys a CDS from Derivative Bank for a notional amount of Rs.10 crores which trades at 200 basis points. In return for this credit protection, the fund pays 2% of 10 crores (Rs. 200,000) in quarterly installments of Rs. 50,000 to Derivative Bank. If Risky Corporation does not default on its bond payments, the fund makes quarterly payments to Derivative Bank for 5 years and receives its 10 crores loan back after 5 years from the Risky Corporation. Though the protection payments reduce investment returns for the fund, its risk of loss in a default scenario is eliminated. If Risky Corporation defaults on its debt 3 years into the CDS contract then the premium payments would stop and Derivative Bank would ensure that the fund is refunded for its loss of Rs. 10 crores Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.

P.S. This is not a technical note but just to give you an idea and introduction as how flexible derivatives can be !!!!

Accounting Standard (AS) 20, ‘Earnings Per Share’ is mandatory in nature, in respect of enterprises whose equity shares or potential equity shares are listed on a recognised stock exchange in India.

An entity which has neither equity shares nor potential equity shares which are listed nee not calculate and disclose earnings per share.

But, if that enterprise discloses earnings per share for complying with the requirements of any statute or otherwise, it should calculate and disclose earnings per share in accordance with AS 20.

Part IV of the Schedule VI to the Companies Act, 1956, requires, among other things, disclosure of earnings per share.

Accordingly, it has been clarified that every company, which is required to give information under Part IV of the Schedule VI to the Companies Act, 1956, should calculate and disclose earnings per share in accordance with AS 20, whether its equity shares or potential equity shares are listed on a recognised stock exchange in India or not.

Call rates have fallen to absurd levels of 0.10% which means banks are lending to each other almost free. This is an indication of how much surplus liquidity is sloshing in the economy. RBI has placed a cap of Rs.3000 crore cap on the amount that the banks can place with RBI on repo - this effectively means that even RBI is scared of being saddled with the huge liquidity at the disposal of the banks. However this situation seems paradoxical - on the one hand you have so much of liquidity in the system while on the other hands interest rates on lending rule between the 12-14% band.

RBI has announced auction of dated securities of Rs.9000 crores and the cap on the repo would force the bank to subscribe to these bonds if call rates continue to rule at these absurd japanese levels.So this excess liquidity could be a temporary phenomena - however this raises questions on other issues - If call rates were ruling at such levels banks should be making a beehive to purchase government securities to take advantage of arbitrage opportunity provided by the rate differential - Imagine borrowing Rs.100 at 0.01% and investing it in a security which will give a 7.39%. However this has not happened which indicates that the banks are not comfortable investing in government securities at this point of time and would rather lend in call at almost free of cost.

Sharp and fleetfooted corporates would look to take advantage of this opportunity to issue short term corporate papers like CPs etc. However there might be reluctance on the part of the banks to subscribe to these issue as at the back of mind every one knows that these kind of interest levels are only short term phenomena.

This high liquidity scenario can be attributed to a couple of reasons: a redemption of a bond infused Rs.20000 crores into the system. Moreover in a bid to support the rupee the RBI has continuously been buying dollars and hence pumping rupee into the system. Rupee has touched an alltime high of Rs.40.28 and seems likely to breach this also.... Overall .... Interesting times ahead --- keep watching this space