Derivatives Market and Credit Default Swaps - Complete Guide with Examples | MODULE D: FINANCIAL PRODUCTS AND SERVICES

Derivatives Market and Credit Default Swaps (CDS)

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Derivatives are financial contracts whose value is derived from the performance of an underlying asset, index, or interest rate. These financial instruments are used for hedging risk, speculation, and gaining access to additional assets or markets.

What is a Derivative?

A derivative is a financial contract whose value is based on the price movements of an underlying asset such as stocks, bonds, commodities, currencies, interest rates, or market indices.

History of Derivatives

The concept of derivatives dates back to ancient Mesopotamia around 2000 BC where merchants used basic forms of forward contracts for trade. Modern derivatives markets evolved in the 17th century with the establishment of the Amsterdam Stock Exchange and later the Chicago Board of Trade (CBOT) in the 19th century.

Size of the Derivatives Market

The derivatives market is one of the largest financial markets globally, with notional outstanding values estimated in the hundreds of trillions of dollars, primarily in interest rate derivatives and credit derivatives.

Underlying Assets

Underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indices. Derivatives derive their value based on the price movements of these assets.

Exchange Traded vs Over-the-Counter (OTC) Markets

• Exchange-Traded Derivatives: Standardized contracts traded on regulated exchanges like NSE, CME, etc.
• Over-the-Counter (OTC) Derivatives: Customized contracts traded directly between parties without an exchange.

Participants in the Derivatives Market

• Hedgers: Use derivatives to manage risk associated with price movements.
• Speculators: Seek to profit from price changes in the underlying asset.
• Arbitrageurs: Take advantage of price differences between markets.

Functions of Derivatives

• Risk management and hedging
• Price discovery
• Market efficiency improvement
• Access to unavailable assets or markets

Types of Derivatives

• Forward Contracts
• Futures Contracts
• Options
• Swaps

Forward Contracts

A forward contract is an agreement between two parties to buy or sell an asset at a future date for a predetermined price. It is customized and traded OTC.

Futures Contracts

Futures contracts are standardized forward contracts traded on exchanges. They involve a legally binding agreement to buy or sell an asset at a predetermined future date and price.

Mathematical Example: Futures Pricing

The theoretical price of a futures contract is given by:

F = S × e^r×t

• F = Futures Price
• S = Spot Price
• r = Risk-free rate (annualized)
• t = Time to maturity (in years)

Example: Spot price (S) = ₹100, Risk-free rate (r) = 5% per annum, Time (t) = 0.5 years.

F = 100 × e^(0.05×0.5) ≈ 100 × 1.0253 = ₹102.53

Options

Options give the holder the right, but not the obligation, to buy or sell an asset at a specified price before a specified date. There are two types: Call options (buy) and Put options (sell).

Advanced Mathematical Example: Black-Scholes Option Pricing Model

The Black-Scholes formula for a call option price is:

C = S₀Φ(d₁) - Xe^-rtΦ(d₂)

• d₁ = [ln(S₀/X) + (r + σ²/2)t] / (σ√t)
• d₂ = d₁ - σ√t

Where:

• S₀ = Current stock price
• X = Strike price
• r = Risk-free interest rate
• t = Time to maturity
• σ = Volatility of the underlying asset
• Φ = Cumulative distribution function of the standard normal distribution

Swaps

A swap is a derivative contract through which two parties exchange financial instruments, typically cash flows based on a notional principal amount. Common types are interest rate swaps and currency swaps.

Credit Default Swaps (CDS)

A CDS is a financial derivative that allows an investor to "swap" or offset their credit risk with that of another investor. The buyer of a CDS pays a periodic fee to the seller, and in return, receives a payoff if a credit event (e.g., default) occurs.

RBI Guidelines on Credit Default Swaps

The Reserve Bank of India (RBI) has issued regulations permitting the use of CDS for corporate bonds by financial institutions. Key guidelines include:

• Only banks and Primary Dealers (PDs) are allowed to act as market-makers.
• Users are permitted to buy protection only to hedge their credit risk.
• Mandatory documentation and reporting norms apply.

Documentation for Derivatives – ISDA Agreement

The International Swaps and Derivatives Association (ISDA) Agreement standardizes derivative transactions between parties and covers important terms such as events of default, netting provisions, and collateral management.

Components of ISDA Documentation:

• Master Agreement
• Schedule to the Master Agreement
• Credit Support Annex (CSA)
• Confirmation

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Chapter List: MODULE D: FINANCIAL PRODUCTS AND SERVICES

• Overview of Financial Markets
• Money Markets and Capital Markets
• Fixed Income Markets - Debt / Bond Markets
• Forex Markets
• Interconnection of various markets/Market Dynamics
• Merchant Banking Services
• Derivatives Market including Credit Default Swaps
• Factoring, forfaiting & Trade Receivables Discounting System (TReDS)
• Venture capital
• Leasing and Hire Purchase
• Credit Rating agencies & their functions
• Mutual Funds
• Insurance Products
• Pension Funds (include APY, NPS)
• Guidelines on Para Banking & Financial Services provided by Banks
• Real Estate Investment Funds / Infrastructure Investment Fund (concept)