Jaimini Bhagwati: Credit derivatives in India?

Derivatives could be another instrument that would help improve efficiency in the allocation of capital.

Indian equity and fixed income markets have been periodically afflicted by so-called "scams". Retail investors have been among the worst affected in such situations since their access to information was limited compared to institutional and professional market participants. In this context, our financial sector regulators and investor associations have improved investor awareness of the market, credit, and operational and legal risks involved when investments are made directly or for example through mutual funds, banks, non-banking financial companies and plantation companies.

A month ago one of our prominent English language dailies carried a major international bank's advertisement, which claimed that its deposit instruments were free of market risk! The market value of a deposit goes up/down as interest rates fall/rise. Further, the depositor is exposed to credit risk, namely that the deposit taker may default. The latter is relevant if the deposit is not fully covered by deposit insurance. This is just one example but is representative of the information asymmetry between investors and issuers in our deposit and corporate debt markets. Reliable numbers on defaults and particularly delays in coupon and principal redemption payments in our corporate fixed income markets are difficult to obtain.

In this regard, credit rating agencies provide useful guidance through their corporate ratings. However, not all entities rated below the investment grade are necessarily at the same level of financial standing. Rating agencies do not find it cost-effective to further differentiate between entities accorded the same low ratings. Invariably though, there are smaller regional banks, venture capital and hedge funds who are familiar with the relative financial soundness of potential issuers who have weak credit ratings or no ratings at all. Such niche-market banks and funds are able to take some of the credit risk of less established companies on their books. Financial intermediaries use credit derivatives to allocate credit risk in ways that are acceptable to hedge funds, etc. Thus, credit derivatives address the information asymmetry between issuers of debt and investors and enable lower-rated companies to raise debt capital.

Credit derivatives are off-balance sheet instruments that enable a party to unbundle the credit risk of a "reference" instrument, e.g. ownership of a bond from market and other risks and transfer it to another party. The first party, which could be an investor, corporate, parastatal or a sovereign is the beneficiary and the second party, usually called the guarantor, is a market intermediary (e.g. an investment bank). In such transactions the beneficiary is able to transfer credit risk, by paying an "insurance premium", without having to sell or dispose of the asset. A widely used credit derivative is the credit-default swap (CDS), which can be customised in the same way as interest rate or currency swaps. Under a CDS, the buyer of credit risk protection on e.g. a bond receives the difference between the face value of the bond and its negligible or zero market value if the issuer were to default.

The basics of pricing credit risk are as follows. Consider two bonds""one a just-issued five-year maturity zero-coupon government bond with a redemption value of Rs 100, trading at Rs 90; the other a zero-coupon corporate bond with a redemption value of Rs 100 and five years left for maturity. The second (corporate) bond will trade at below Rs 90 because corporate bonds usually carry higher credit risk as compared to corresponding maturity sovereign bonds. Let us say the second bond trades at Rs 84 (coupon bearing bonds can be priced as the summation of zero-coupon bonds). The difference between the present values of the two instruments, Rs 6 (90 - 84), reflects the market's lower appetite for a higher credit risk corporate bond as compared to a "risk-free" government bond.

In current market conditions credit derivatives may appear irrelevant as a means to increase corporate access to debt funding. In an environment of increasing stock valuations bigger companies are either cash-rich and/or have easy access to capital. However, the cost of capital remains one of the major barriers to entry for smaller and less known companies. Additionally, there is the potential start-up, which would add to competition if it had access to capital.

It will not be easy to develop domestic credit derivatives markets in India. According to a biennial report (end 2004) of the British Bankers' Association (BBA) the notional principal in the global market for credit derivatives rose from about $900 billion at the end of 2001 to about $3.5 trillion by the end of 2003. Out of this about $250 billion (approximately 7%) of notional principal were contracts written on assets that belonged to sovereign emerging market participants. This BBA report anticipates that the credit derivatives market for emerging market assets will grow to about $600 billion by the end of 2006.

International CDS markets are relatively underdeveloped compared to interest rate or currency swap markets. The notional principal per transaction, on average, is only about $5-10 million and in the secondary market bid-offer spreads are wide, ranging from 0.05%-5%. Among developing countries, e.g. in Mexico, CDSs can have final maturities ranging up to 10 years. Usually, even for better-known companies final maturities do not extend beyond five years.

As of end 2004, less than a 1,000 emerging market entities had contracted credit derivatives and less than 200 had contracts that were traded and liquid. About 30 pertained to emerging market sovereigns. Mexico, Brazil and Russia were the principal markets for sovereigns and corporate energy companies. International banks do hedge credit risk in emerging markets using credit derivatives but growth in cross-country markets has been constrained by political, convertibility and legal risks.

Most of the promotional work (e.g. by the International Swap Dealers' Association""ISDA) has been done with reference to developed country financial intermediaries who provide credit risk intermediation within their national jurisdictions or in the context of exposures to emerging markets. Consequently, emerging economies need to make their own efforts to promote the development of credit derivatives markets. In India, the ministry of finance and our financial sector regulators could begin by taking co-ordinated action to develop the domestic CDS market. If there is appropriate dissemination of information and adequate regulatory oversight credit, derivatives could be another instrument that would help improve efficiency in the allocation of capital.

j.bhagwati@gmail.com