Credit Default Swaps (CDS)

In News

• Recently, the regulator Securities and Exchange Board of India (Sebi) allowed alternative investment funds (AIFs) to participate in the Credit Default Swaps (CDS) market.

New Norms

• For Buying:
  • Under the new norm, Category-I and Category-II AIFs can buy CDS on underlying investment in debt securities only for the purpose of hedging.
  • Category-III AIFs can purchase CDS for hedging or otherwise, within permissible leverage.
• For Selling:
  • Category-II and Category-III AIFs may sell CDS by earmarking unencumbered government bonds or Treasury bills equal to the amount of the CDS exposure. 
• Significance:
  • The new norms will allow business entities to hedge risks associated with the bonds market.
  • These norms will facilitate deepening of the domestic corporate bond segment. 

Credit Default Swaps (CDS)

• About:
  • A CDS is a type of derivative that transfers the credit exposure of fixed income products.
  • CDS is a specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to another.
  • CDS can be used for speculation, hedging, or as a form of arbitrage.
  • Credit default swaps played a role in both the 2008 Great Recession and the 2010 European Sovereign Debt Crisis.
• Process:
  • In a credit default swap contract, the buyer pays an ongoing premium similar to the payments on an insurance policy. 
  • In exchange, the seller agrees to pay the security’s value and interest payments if a default occurs.

Source: ET