Alternate Investment Fund and Credit Default Swap 

In News: The Securities and exchange board of India has allowed alternative investment funds) to participate in credit default swaps (CDS) as protection for both buyers and sellers.

• Category I and Category II AIFs may buy CDS on underlying investment in debt securities, only for the purpose of hedging.
• Category III AIFs may buy CDS for hedging or otherwise, within permissible leverage
• Credit default swap market is very illiquid at present.

Alternate Investment Fund(AIFs):

• In India, AIFs are defined in Regulation 2(1) (b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
• Meaning – It refers to any privately pooled investment fund, (whether from Indian or foreign sources), in the form of a trust or a company or a body corporate or a Limited Liability Partnership (LLP).
• They include angel funds, commodities, real estate, venture capital, private equity, etc.
• Categories of AIFs

• Category I: Mainly invests in start- ups, SME’s or any other sector which Govt. considers economically and socially viable
• Category II: private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other Regulator
• Category III : hedge funds or funds which trade with a view to make short term returns or such other funds which are open ended and for which no specific incentives or concessions are given by the government

Benefits of AIF:

• Security against volatility – These schemes do not put their funds in investment options that trade publicly. Hence, they are not related to the broader markets and do not fluctuate with their ups and downs.
• Excellent portfolio diversification to a wide array of assets
• Profitable returns – as these funds have numerous investment options, They are a better source of passive income. Further, returns are less prone to fluctuations as these schemes are not linked to the stock market.

Credit Default Swap (CDS)

• They are a type of insurance, introduced by JP Morgan
• It is used for hedging counter-party concentration risk and credit risks
• It is a contract between two parties, called protection buyer and protection seller against default risk by a particular company.
• The company is called the reference entity and the default is called credit event.
• Under the contract, the protection buyer is compensated for any loss emanating from a credit event in a reference instrument. In return, the protection buyer makes periodic payments to the protection seller.
• In the credit event, the buyer receives the face value of the bond or loan from the protection seller.
• From the seller’s perspective, CDS provides a source of easy money if there is no credit event.
• If the credit event does not occur before the maturity of the loan, the protection seller does not make any payment to the buyer.
• The settlement of the CDS takes place either through cash settlement or physical settlement.
• There are different varieties of CDS, like binary CDS, basket CDS, contingent CDS and dynamic CDS.
• There are different types of credit events such as bankruptcy, failure to pay, and restructuring.
• Asset-backed securities (ABS) is the most common type of CDS.
• CDS can be structured either for the event of shortfall in principal or shortfall in interest. There are three options for calculating the size of payment by the seller to the buyer.

• Fixed cap: The maximum amount paid by the protection seller is the fixed rate.
• Variable cap: The protection seller compensates the buyer for any interest shortfall and the limit set is Libor plus fixed pay.
• No cap: In this case, the protection seller has to compensate for shortfall in interest without any limit.

Calculation:

• The modelling of the CDS price is based on modelling the probability of default and recovery rate in the event of a credit event.

• The value of CDS for the protection buyer = Expected present value of the contingent leg – Expected present value of fixed leg
• In the real world, modelling of the CDS price is difficult because of the problem in computing default probabilities and default correlation.

Uses:

• Although used for hedging credit risks, credit default swap (CDS) has been held culpable for vitiating financial stability of an economy.
• This is particularly attributable to the capital inadequacy of the protection sellers.
• When big protection sellers are inadequately capitalised, the over-the-counter (OTC) CDS market raises its ugly head.

Sources: Financialexpress

Previous Year Question

Q.1) What does venture capital mean? (2014)

1. A short-term capital provided to industries
2. A long-term start-up capital provided to new entrepreneurs
3. Funds provided to industries at times of incurring losses
4. Funds provided for replacement and renovation of industries