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Kerala PSC Indian Economy Book Study Materials Page 404
Book's First Page14.24 ndian onom It operates like an insurance policy. In an which may not otherwise be available, insurance policy, the insurance firm pays the and increase the yield on his portfolio. loss amount to the insured party. Similarly, the (iv) Banks can use it to transfer risk to other buyer of the CDS—the bank or institution that risk takers, create capital for more lending. has invested in a corporate bond issue—seeks to (v) Distribute risk widely throughout the mitigate the losses it may suffer on account of a system and prevent concentrations of risk. default by the bond issuer. Credit default swaps Some analysts have serious apprehensions allow one party to ‘buy’ protection from another about CDS. George Akerlof, Nobel prize-winning party for losses that might be incurred as a result economist, in 1993, predicted that the next of default by a specified reference instrument (a meltdown will be caused by CDS. In 2003 bond issue in India). The ‘buyer’ of protection investment legend Warren Buffet called them as pays a premium to the seller, and the ‘seller’ of ‘weapons of mass destruction’. The former US protection agrees to compensate the buyer for losses incurred upon the occurrence of any one Federal Reserve Chairman Alan Greenspan, who of the several specified ‘credit events’. Thus CDS betted big on CDS said after the ‘sub prime’ crisis offers the buyer a chance to transfer the credit risk that ‘CDS are dangerous’. A leading US weekly of financial assets to the seller without actually the Newsweek described CDS, ‘the monster that transferring ownership of the assets themselves. ate Wall Street’. Many Indian experts had the opinion that ‘CDS will not stabilise the economy Let us try to understand it by an example. rather could lead to destabilisation’. Suppose Punjab National Bank (PNB) invests in Rs. 150 crore bond issued by TISCO. If CDS contract are dangerous because they PNB wishes to hedge losses that may arise from can be manipulated for mischief. It’s all about the a default of TISCO, then PNB may buy a credit insurable interest which is never there as it is used default swap from a financial institute, suppose, for speculation. A derivative that amounts to an Templeton. PNB will pay fixed periodic payments insurance contract with no insurable interest is to Templeton, in exchange for default protection bad. But do the speculators have insurable interest? (just like premium of an insurance policy). No they don’t have any. The US ‘sub prime’ crisis was a fallout of such CDS contracts—one CDS can be used for different purposes in a defaulting and another claiming the ‘protection’ financial system, viz., finally resulting into the defaulter of the insuring (i) Protection buyers can use it to hedge company—overnight the biggest US insurance their credit exposure while protection giant, AIG went bankrupt. So happened with sellers can use it to participate in credit many US banks also. markets, without actually owning assets. The most damaging aspect of CDS is that the (ii) The protection buyer can transfer credit credit risk of one country/region gets exported to risk on an entity without transferring another country/region very smoothly and silently. the under lying instrument, reap regular Thus There is a serious chance of ‘contagion effect’ benefit in terms of lower capital charge, suppose there are defaulters there, the thing which seek reduction of specific concentrations happened during the US ‘sub prime’ crisis. in credit portfolio and go short on credit risk. SecuritiSation (iii) The protection seller will be able to diversify his portfolio, create exposure to This is the process of issuing ‘marketable securities’ a particular credit, have access to an asset backed by a pool of existing assets such as auto