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Credit derivatives : focusing on the Indian credit derivatives market PDF

445 Pages·2014·5.295 MB·English
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A P DVANCE RAISE FOR C D REDIT ERIVATIVES ‘a really comprehensive [and] thorough treatise. … an essential road map for students, investors, traders, and regulators of credit derivatives anywhere in the world, especially in new markets, where these securities are being introduced. … accessible for readers coming at the subject at different levels of quantitative training, and for practitioners of varied viewpoints. There is something here for everyone interested in the credit markets.’ —Professor Sanjiv Das, William and Janice Terry Professor of Finance, Santa Clara University ‘a very well-written introduction to credit derivatives, with an emphasis on credit default swaps. … covers a wide swath of material on the topic and includes recent developments and regulations in India, in addition to its usage in more mature, developed markets. The reader can see how useful these instruments are; while, at the same time, understand their ability to magnify bad outcomes. … It covers all the essentials in a very easy to follow, structured, conversational style. I strongly recommend the book.’ —Professor Suresh Nair, Professor and Ackerman Scholar, University of Connecticut ‘a timely and much-needed volume about a key and less-than-widely- understood class of instruments of financial risk sharing that can only gain in importance in the years to come. A must-read for all serious students and practitioners of finance as well as policymakers.’ —Professor Rajesh Chakrabarti, Executive Director, Bharti Institute of Public Policy, Indian School of Business ‘This book is a significant contribution to finance literature. It explains Credit Derivatives market in detail and in simple terms including its specifications, valuation, accounting and legal issues. I am sure, a wide cross-section of market participants would be able to come up to speed and would benefit immensely from this book.’ —G. Gopalakrishna, Director, Centre for Advanced Financial Research and Learning (CAFRAL), Reserve Bank of India ‘The timing of the book is very apt as it comes closely on the heels of policymakers and market participants grappling with what is the right way to get Credit Derivatives going in the onshore market. … This book does justice by bringing into attention the goodness of the product as well as the red herring of the product. … a very well timed book, quite comprehensive in its scope and a must-read for someone who intends to understand the subject. … Vaidya blends concepts and practice very well and makes full justice of his background.’ —Anup Bagchi, Chief Executive Officer and Managing Director, ICICI Securities Limited ‘This book takes up a complex topic and succeeds largely in simplifying it for the reader. It is essential reading for those wanting an introduction to credit derivatives.’ —Anantha Nageswaran, Former Chief Investment Officer and Head of Research, Julius Baer, Singapore ‘The book systematically explains product mechanics and lucidly places them in the context of regulatory frameworks. It would be of value to market practitioners, policymakers, academics and regulators alike.’ —Dr Ranjan Chakravarty, Former Chief Risk Officer, Singapore Mercantile Exchange and Clearing Corporation ‘the book has tremendous learning value. Vaidya provides an easily comprehensible, building-block approach to credit derivatives, starting from the basics to discussion on esoteric instruments. Recent developments such as Big Bang have also been discussed at length. To complete the picture, Vaidya provides guide to ISDA documentation, regulatory issues as well as accounting treatment. Vaidya not only explains the subject, but concludes the book by providing his take on the policy implications on the subject. Vaidya’s book would be a great read and a reference for anyone interested in this fascinating subject.’ —Vinod Kothari, internationally renowned Author and Expert on credit derivatives ‘The appealing part of the book … is the lucid style of presentation of a complex subject like credit derivatives. The coverage is full, even though the complex mathematical pricing issues have been avoided. This book will be useful to students as well as practitioners. With India opening the market for credit derivatives, this book is a very timely addition in enhancing the knowledge on this subject.’ —Professor B.B. Chakraborty, Director, Indian Institute of Management, Ranchi ‘Bankers have been searching for a book like this. … a comprehensive book on credit derivatives. It discusses the credit default swap instrument as it is used in India and risk management along with the pertinent RBI guidelines. This book addresses a long-felt need for a complete handbook for credit derivatives.’ —N.S. Venkatesh, Executive Director, IDBI Bank Former Managing Director and Chief Executive Officer of IDBI Gilts ‘This is a compulsory read for entry level professionals whose work concerns credit derivatives. The book covers in sufficient depth and detail, financial, accounting and legal aspects related to credit default swaps in India. The policies and guidelines in the appendix are impressive and informative.’ —K. Selvaraj, Former Chairman FIMMDA and Head of Forex, Financial Engineering & New Products, State Bank of India ‘This book is a well written text on the subject and covers most of the aspects required to be known by the Traders as well as Risk Managers, and is a good piece of reference.’ —Ashutosh Khajuria, President – Treasury, Federal Bank ‘The book has excellent coverage of Credit Derivatives and is quite pertinent in the Indian Financial Markets context. I would recommend it as a mandatory reading for all capital market professionals and as a reference book for senior bankers in India.’ —Ashish Agarwal, Chief Risk Officer, Yes Bank ‘one of the masterpiece works. The release of the book is both topical and timely … a refresher book for treasury managers, risk managers, traders and investment bankers and a “must-read” book for students and teachers of finance.’ —V. Sriram, General Manager, SIDBI K. Vaidyanathan Faculty in Residence University of Connecticut McGraw Hill Education (India) Private Limited NEW DELHI New Delhi New York St Louis San Francisco Auckland Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal SanJuan Santiago Singapore Sydney Tokyo Toronto Published by McGraw Hill Education (India) Private Limited, P-24, Green Park Extension, New Delhi 110 016. Credit Derivatives Copyright © 2014, McGraw Hill Education (India) Private Limited. No part of this publication may be reproduced or distributed in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise or stored in a database or retrieval system without the prior written permission of the publishers. The program listings (if any) may be entered, stored and executed in a computer system, but they may not be reproduced for publication. This edition can be exported from India only by the publishers, McGraw Hill Education (India) Private Limited. Print Edition ISBN (13): 978-1-25-902841-0 ISBN (10): 1-25-902841-0 E-book Edition ISBN (13): 978-93-392-1321-3 ISBN (10): 93-392-1321-3 Managing Director: Kaushik Bellani Publishing Manager—Professional: Mitadru Basu Sr. Production Executive: Rita Sarkar DGM—Sales and Business Development—Professional: S. Girish Asst. Product Manager—BGR: Priyanka Goel General Manager—Production: Rajender P. Ghansela Manager—Production:Reji Kumar Information contained in this work has been obtained by McGraw Hill Education (India), from sources believed to be reliable. However, neither McGraw Hill Education (India) nor its authors guarantee the accuracy or completeness of any information published herein, and neither McGraw Hill Education (India) nor its authors shall be responsible for any errors, omissions, or damages arising out of use of this information. This work is published with the understanding that McGraw Hill Education (India) and its authors are supplying information but are not attempting to render engineering or other professional services. If such services are required, the assistance of an appropriate professional should be sought. Typeset at Script Makers, 19, A1-B, DDA Market, Paschim Vihar, New Delhi 110063 and printed at *** Cover Printer: Cover Designer: Kapil Gupta *** F OREWORD Credit risk represents the key risk that commercial banks assume. In recent years, new instruments for managing credit risk have evolved in emerg- ing financial markets. Credit Default Swap (CDS) is one such instrument that has been introduced in the last couple of years in India and China by their respective Central Banks. CDS allows banks to separate credit origination from credit risk. From an economic point of view, this separation generates benefits as banks can extend their lending without being constrained by their risk-taking capacity. By buying or selling credit protection, banks make the credit risk tradable and shift the credit risk out of their balance sheets to other market participants who are better able to bear this risk or who wish to diversify their portfolios. In India, the Reserve Bank of India (RBI) introduced CDS for banks and security houses in November 2011. Subsequently, the Securities and Exchange Board of India (SEBI) allowed Mutual Funds to use CDS in November 2012. In December 2012, Insurance Regulatory and Development Authority (IRDA) permitted the use of CDS for insurance companies in India. Since credit derivatives are relatively new to Indian financial markets, a clear understanding of this instrument is a must for practitioners, regulators, academics and students. Vaidya’s book fulfils this important need as it covers the essential body of knowledge to provide a good understanding of this newly introduced asset class. Vaidya has been a practicing professional who honed his craft at one of the leaders in credit derivatives market. The book reflects this practitioner orientation: it covers the essential nuts and bolts of this asset class in a lot more detail when compared to standard textbooks. Features of CDS contracts are explained in detail; these include their standard fee structure, payment dates, standardization of accruals, frequency, scheduled termination dates, day count conventions, maturity, reference entities, reference obligations, etc. The book covers the valuation of both x Foreword liquid and illiquid CDS taking the CDS conventions into account, as is the market practice. Investor strategies and indices are discussed, as also the new conventions in the global credit derivatives market such as the big-bang and the small-bang protocols. The book describes in reasonable detail the settlement of CDS contracts in case there is a credit event; both eventualities of physical and cash settlement are covered. In the case of physical settlement, the conditions for payment, such as the credit event notice period and Notice of Physical Settlement (NoPS) are covered in necessary detail. In case of cash settlement, the process that would be followed by the Indian Credit Derivatives Determinations Committee set up by the RBI nominated entity—FIMMDA (Fixed Income Money Market and Derivatives Association of India) is included in appropriate detail. Regulatory treatment of Credit Derivatives under the Basel III framework as well as the simpler framework used by the RBI is reviewed. The accounting treatment for CDS, more specifically, hedge accounting for CDS under the FAS, IFRS and Indian Accounting standards are covered. The last three chapters deliberate on the evolution of the market for credit derivatives, their real effects on the economy, and their policy implications. Vaidya’s book provides a complete treatment of this important and in- novative asset class. I foresee it being a standard reference for all stake- holders of this financial product in India. VIRAL V. ACHARYA C.V. Starr Professor of Economics, Department of Finance, NYU Stern School of Business, New York Director, NSE-NYU Stern Initiative on the Study of Indian Capital Markets Research Associate in Corporate Finance, National Bureau of Economic Research (NBER) Research Affiliate, Centre for Economic Policy Research (CEPR)

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