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What are
Credit Derivatives?
BY Prashant Raj Dangol
Credit Derivatives are financial instruments/contracts that are used to trade credit risks. They are contracts that transfer asset’s risk and return from one counter party to another without transferring ownership of underlying assets. It can be defined as arrangements that allow one party (protection buyer or originator) to transfer credit risk of a reference asset, which it may or may not own, to one or more other parties (the protection sellers). For example, if bank A enters into a credit derivative with bank B relating to the former’s portfolio, bank B bears the risk, of course for a fee, inherent in the portfolio held by bank A, while bank A continues to hold the portfolio.
Types of Credit Derivatives: The most traditional form of a credit derivative is a guarantee and at present, the concept of credit derivatives has travelled much farther than a simple bank guarantee. The credit derivatives being currently used in the market can be classified as follows:
Credit default swap (CDS or credit swap): The protection buyer pays a fixed recurring amount to the protection seller in exchange for a payment to be made by the latter, which is contingent upon happening of a future credit event. The credit event is usually a default made on the credit portfolio. In an instance when no pre-specified credit event occurs during the life of transaction, the protection seller receives the periodic payment in compensation for assuming the credit risk on the Reference Entity/Obligation. Conversely in the instant that any one credit event occurs during the life of transaction, the protection buyer will receive the amount previously agreed upon to cover the credit loss as a result of the default.
Total rate of return swap (TROR or TR SWAP): A total rate of return swap is a swap of the total return out of a credit asset against a contracted prefixed return. This is a bilateral contract (financial) in which the total economic return of an asset (income plus or minus any change in capital value) during the holding period is exchanged for another cash flow. The main difference of the TROR swap with CDS is that while a credit default swap is credit event specific, the TROR exchanges the cash flows irrespective of any credit event. Credit default swap only transfer credit risk while a TROR not only transfer to credit risk (i.e. the improvement or deterioration in credit profile of an issuer) but also the market risk (i.e. any increase or decrease in general market prices). In TROR, payments are exchanged among counter parties upon changes in market valuation of the underlying, in addition to the occurrence of a credit event as is the case with CDS contracts.
The protection buyer pays all cash flows received from owned assets (the reference asset such as bond debenture etc.) to the protection seller. If the asset increases in value, the protection buyer pays the change in price of the assets. On the other hand if the reference assets goes down in value, the protection buyer receives the change in price from the protection seller. In exchange of the cash flow, the protection seller makes periodic payment to the protection buyer on the basis of a pre arranged interest rate.
Credit link note (CLN): CLNs are created through a Special Purpose Corporations or Vehicles (SPCs or SPVs), or trust, which is collateralised with AAA-rated securities. Under this structure, the coupon or price of the note is linked to the performance of a reference asset. Investors buy the securities from the trust that pays a fixed or floating coupon during the life of the note. The payments are, however, linked to the value of the reference assets or the original credit portfolio. The SPC uses the money mobilised from the investors in purchasing high rated collateral security. The investors receive a fixed or floating coupon during the life of the note and at maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy. If, however, there occurs a default in reference assets, the investor receives only the recovery value on maturity. In the event of a credit default, the SPC compensates the protection buyer by liquidating the collateral securities. Therefore in a CLN derivative the credit risk is finally assumed by the general investor in exchange for a risk related effort.
Every commercial bank has both group-wise and activity-wise exposure limits. Banks can use the credit derivatives to diversify their portfolio of loans and other risky assets by avoiding concentration risk. Suppose Bank A is specialised in X type of industries but has not invested in Y type of industries whereas on the other hand Bank B is specialised in Y type of industries and has not invested in X types of industries. In this situation, by entering into credit derivatives agreement both the banks, without transferring their portfolio or reducing their portfolio can transfer their risk. Credit derivatives will bring greater efficiency of pricing and greater liquidity. With enhanced liquidity, credit derivatives will help both buyer and seller of risk benefit from the associate efficiency gain-a win-win situation.
(Dangol is associated with the Machhapuchchhre Bank Ltd.)
Bait and Switch Advertising
BY Sajeeb Kumar Shrestha
Bait and switch advertising is a common form of false advertising. This form of advertising takes place when a seller advertises a particular item at a bargain price to attract you into the store (bait). However, when you arrive at the store, you find that the discounted item is “sold out” or the salesman convinces you that the advertised item is of an inferior quality and instead offers you a different, more expensive item (switch).
Ethical advertising requires that when a seller advertises goods at discounted prices they must be able to supply those goods for a reasonable length of time. If the special offer is on for only a limited period or if stocks are genuinely low, this must be made clear in the advertisement.
The truth about bait and switch advertising is that the store never actually intends to sell the advertised special. The idea is to “kill” your desire of buying what is advertised and then trying to get you to buy a similar but more expensive item.
Bait and switch advertising does not only cheat the consumer, it is also anti-competitive. By advertising products, which are not available in reasonable quantities, at bargain prices, retailers can unfairly lure consumers to their stores, thereby taking business away from competitors. The loyal customer base of competitors begins to slip away and new customers may not even consider entering the competitor’s store.
Bait and Switch Ads in Nepal
Though clearly declared illegal in many countries, bait and switch advertising is widely practised in Nepal . Three or four years ago, Singh PC had advertised the “Free PC Offer” in many newspapers. If you helped sell three computers through Singh PC, you’d get one PC free. After some time, the company was closed down due to the low quality computer parts used and the failure to fulfil their promise to give away free PCs.
In various trade fairs, some companies quote fantastically low price for their products but when you go to their shop, they say that the lower priced stock has been sold out and you are offered a higher priced substitute.
For example, many companies in the CAN Info-Tech demonstrate their computer as working fast (by using fast Intel Processors, the latest 2.6Ghz, and Intel Original Motherboard). The customer is impressed by that computer and when he buys it from the company’s store, the computer cannot perform as well as was shown in the CAN Info-Tech, because an Intel Celeron Motherboard and Intel Celeron Processor are used instead of the original Intel.
In the recent past, popular artist Madan Krishna Shrestha hosted a TV quiz show - “Nagad Paanch Laakh”, in which if a person won some amount of money he would be given a cheque for the amount signed by him as the programme host. The winners, however, later complained of bounced cheque and the programme was discontinued but nobody knows if any action was taken against the programme organisers.
A more recent example is of Cosmic Air which advertised a drastic reduction in fares when it introduced Jet service for domestic routes. When the passengers planned their travel accordingly (avoiding travel by bus), they found out that only a few seats in the Cosmic Air Jet were available for the reduced fares. So they were forced to buy more expensive air tickets. The catch was in the words “Conditions Apply” used in the advertisement. It may be noted that advertisements with “Conditions Apply” are very common in Nepal , so many of such ads may be examples of bait and switch advertising.
Lesson to be learnt: Be careful with ads that specify “Conditions Apply”. It may be a bait to switch you on to expensive products or to cheat you by some other means. Such a practice is growing in Nepal because there is no law against it.
(Shrestha teaches management in Shanker Dev Campus.)
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