CDS (Credit Defalut Swap)

Harshit Gupta

Bank of America C...

CDS is kind of Swap Derivative. its a good hedging instrument, work more or less like insurance. like insurance, buyer of CDS need to pay the spread to seller of CDS, and buyer revieve one time single payment @ time of defalut of reference entity on the basis of calculation done from recovery rate, survival probability & time duration.

latest recession was majorly effected by CDS. big Financial institution like ML, Lehman & AIG got bankrupt.

how broadly its being used in india is still a question mark and if its used, than only on OTC Market. on the other hand in foriegn contries there is regulatory exchange to control.

In India RBI had come up with guide lines. The guidelines could not have come at a more opportune time, as several players are waiting eagerly to get appropriate instruments to manage credit risk in their portfolio.

The guidelines initially are addressed to commercial banks and primary dealers only and the scope is limited to usage of Credit Default Swap by the banks and primary dealers for sale and purchase of credit protection in respect of single resident reference entity. Down the line, it seems that insurance companies and mutual funds also would get to participate in the exciting field of credit derivatives.

The finance ministry does not believe there is an intrinsic problem with CDS. Problems such as the one AIG and its counterparties (or people with whom it had CDS contracts) experienced were on account of flaws in market design, goes the reasoning.

In an exchange-traded format, the clearing houses functions as the legal counterparty for all trades, which effectively neutralizes the possibility of markets freezing when one of the participants defaults.

By not making it (CDS trading) OTC, in an exchange-traded volume you do not get such large transactions. The transparency in exchange-traded format also makes it difficult for a participant to quietly take large positions.