Recently Central Bank Reserve Bank of India (RBI) revealed the credit default swaps (CDS) and has allowed the retail users to do the transactions in permitted credit derivatives in order to hedge their underlying credit risk.

Points To Note

  • As per the RBI guidelines, the non-retail users will be allowed to do the transactions in credit derivatives for the purpose of hedging as well as other purposes.
  • The person who is India citizen and a non-resident can participate in the market.
  • Under this guidelines, the exchanges can offer standardised single-name credit default swaps contracts by specifying guaranteed cash settlement.
  • The commercial papers, listed or unlisted rated rupee corporate bonds, Unrated bonds issued by the special purpose vehicles, certificates of deposit and non-convertible debentures of maturity up to one year are eligible to be a reference or deliverable obligation in the CDS contract.

Credit Default Swap

  • The credit default swaps is a derivative or contract that permits the investor to swap or offset his credit risk with another investor.
  • The swaps is a financial swap agreement where the seller of credit default swaps will compensate buyer in case of a debt default.
  • In such agreement, the seller of credit default swaps insures the buyer against asset defaulting.
  • Here, the buyer of credit default swaps makes a series of payments to the seller and expect to receive payoff in case of asset defaults.
  • In case of asset default, buyer of the credit default swaps receives compensation while the seller of credit default swaps takes possession of the defaulted loan.
  • credit default swaps can be purchased by anyone even those buyers who do not hold the loan instrument can buy credit default swaps.

What is the Hedging?

The Hedging is a risk management strategy that is employed to offset losses in investments. The losses are offset by taking an opposite position in the defaulted asset. Hedging though reduces the risk associated with the assets but it also reduces the potential profits.