Credit Default Swap: Basics

A CDS is a contract that provides protection against the risk of a credit event by a particular company or country. The company is known as the reference entity and a default by the company is known as a credit event. The buyer of the insurance obtains the right to sell a particular bond issued by the company for its par value when a credit event occurs. The bond is known as the reference obligation and the total par value of the bond that can be sold is known as the swap's notional principal. The buyer of protection makes periodic payments to the protection seller until the occurrence of a credit
event or the maturity date of the contract, whichever is first. If a credit event occurs the buyer is compensated for the loss (possibly hypothetically) incurred as a result of the credit event.
A credit event usually requires a nal accrual payment by the buyer. The swap is then settled by either physical delivery or in cash. If the terms of the swap require physical delivery, the swap buyer delivers the bonds to the seller in exchange for their par value.
When there is cash settlement, the calculation agent polls dealers to determine the midmarket price, Q, of the reference obligation some specified number of days after the credit event. The cash settlement is then $(100 − Q)% of the notional principal.

The valuation of a credit default swap requires estimates of the risk-neutral probability that the reference entity will default at di erent future times. The prices of bonds issued by the reference entity provide the main source of data for the estimation. If we assume that the only reason a corporate bond sells for less than a similar Treasury bond is the possibility of default, it follows that:
Value of Treasury Bond - Value of Corporate Bond = Present Value of Cost of Defaults

By using this relationship to calculate the present value of the cost of defaults on a range of different bonds issued by the reference entity, and making an assumption about recovery rates, we can estimate the probability of the corporation defaulting at di erent future times. If the reference entity has issued relatively few actively traded bonds, we can use bonds issued by another corporation that is considered to have the same risk of default as the reference entity. This is likely to be a corporation whose bonds have the same credit rating as those of the reference entity and ideally a corporation in the same industry as the reference entity.
We start with a simple example. Suppose that a ve-year zero-coupon Treasury bond with a face value of 100 yields 5% and a similar ve-year zero-coupon bond issued by a corporation yields 5.5%. Both rates are expressed with continuous compounding. The value of the Treasury bond is
100 x e^(−0.05×5) = 77.8801
and the value of the corporate bond is 100 x e^(−0.055×5) = 75.9572. The present value of the cost of defaults is, therefore
77.8801 − 75.9572 = 1.9229
Define the risk-neutral probability of default during the five-year life of the bond as p. If we make the simplifying assumption that there are no recoveries in the event of a default, the impact of a default is to create a loss of 100 at the end of the five years. The expected loss from defaults in a risk-neutral world is, therefore, 100p and the present value of the expected loss is
100 x p x e^(−0.05×5)
It follows that: 100 x p x e^(−0.05×5) = 1.9229
so that p = 0.0247 or 2.47%.
There are two reasons why the calculations for extracting default probabilities from bond prices are, in practice, usually more complicated than this. First, the recovery rate is usually non-zero. Second, most corporate bonds are not zero-coupon bonds. When the recovery rate is non-zero, it is necessary to make an assumption about the claim made by bondholders in the event of default.

UCITS : Undertakings for Collective investment In Transferable Securities

Off late mutual funds are also showing the aggresion which was once idiosyncracy of hedge funds. Now they are also chasing alpha and craving for absolute returns. Thanks to UCITS, restirctions made easy and derivatives and OTC available as investment avenues.

Background
In simple terms, a UCITS is a mutual fund based in the European Union. UCITS stands for “Undertakings for Collective Investment in Transferable Securities” and UCITS funds can be sold to any investor within the European Union under a harmonised regulatory regime.
They have a strong brand identity across Europe, Asia and South America and are distributed for sale in over fifty countries as they have transparent, tried and tested regulation. The original Directive introducing the concept of a standard fund structure, “UCITS I”1, was adopted in 1985. However, due to differing cross border marketing restrictions in member states and the restricted range of asset classes permitted, the original Directive prevented UCITS from benefiting from the increasing range of investments that were available in the market. A second draft directive – UCITS II – was developed to rectify these issues, however extended political arguing between EU countries caused it to be abandoned.

UCITS III – development for change
It was not until 2003 that UCITS I was amended by a new Directive, UCITS III, which was itself made up of two directives: the Product Directive2 and the Management Directive3. The Product Directive expanded the type and range of investments that a UCITS could hold; The Management Directive sought to give a European passport to management companies of a UCITS fund to enable them to operate throughout the EU as well as tightening up risk management frameworks and increasing managers’ capitalisation requirements. The combined Directive was intended to widen consumer choice and consumer protection. It is this combined UCITS III Directive that fund managers now refer to when they talk about “UCITS-III-compliant” or “Newcits” funds. In general, they mean the fund is taking advantage of the wider investment powers. But there is a good deal more going on behind the scenes. One of the key benefits of the UCITS III Product Directive was the broadening of the investment powers available to mutual funds. This included derivatives for specific investment purposes and it has taken some years for the industry to realise that this enhanced breadth presents managers with the ability to offer a much fuller range of investment products than had previously been the case.
September 2010
ViewPoint
The Management Directive developed the existing concept of the “product passport”, on which BlackRock’s European Retail distribution model is based. Under the passport, a UCITS fund in one member state can be freely marketed to investors in another EU4 country, subject to a processing period of up to two months by the regulator in the other country.
The Management Directive also introduced new prospectus requirements as well as demanding that all UCITS funds use a “Simplified Prospectus” as a marketing document throughout the EEA. Permissions to allow managers to operate funds domiciled in other countries (the “management passport”) was not however a complete success and the new UCITS IV Directive, which will come into force in 2011, in part aims to rectify this.
BlackRock in the UK was one of the first firms to see the possibilities for UCITS III, with the launch in 2005 of UK Absolute Alpha. Since then, we have launched other funds and now offer a wide range of UCITS-III-compliant funds as well as seven “Newcits” funds to UK and European investors, investing in equity, fixed income and foreign exchange.
Regulatory change is constant, now more so than ever, but since UCITS III, further EU Directives, rules and guidance have been published, building on its base. This includes the Eligible Assets Directive5 which formally widened and clarified the scope of UCITS’ investments, the European Commission Recommendation for the use of financial derivative instruments for UCITS6 which introduced additional aspects and demands in risk monitoring and additional guidance by CESR7 on an assortment of matters.


Main Features of a UCITS
A UCITS can only invest in eligible assets. The original UCITS directive was restrictive in scope and effectively allowed only equity and bond funds.
UCITS III expanded the range of available investments to include derivatives for investment purposes, other UCITS and cash. This dramatically increased investor choice, allowing for cash funds, funds of fund, mixed asset funds.

UCITS must operate on a principle of risk spreading, which means that restrictions apply which limit the spread of investments, leverage and exposure. UCITS III, however, re-defined how derivative exposure can be measured.
A UCITS must be open-ended i.e. shares or units in the fund may be redeemed on demand by investors.
A UCITS must be liquid, that is, its underlying investments must be liquid enough to support redemptions in the fund on at least a fortnightly basis. In practice of course, the vast majority of UCITS funds are daily dealing.
Assets must be entrusted to an independent custodian or depositary and held in a ring-fenced account on behalf of investors.

The development of investment powers
Eligible Assets
As part of UCITS III then, the Product Directive expanded the type of available investments to allow a UCITS to invest in derivatives not only for efficient portfolio management “EPM” or hedging purposes but for investment purposes as well.
This has allowed a number of hedge fund strategies to be accommodated within the UCITS format such as equity long/short, relative value, etc. Some strategies, however, will not easily fit within a UCITS framework because the underlying asset class is not permissible (e.g. individual commodities or bank loans) or because of the lack of liquidity (e.g. distressed debt). The eligible assets that a UCITS can invest in include:

Transferable securities – effectively, publicly traded equities or bonds, listed on mainstream stock exchanges. Broadly, this was the range of assets allowed under UCITS I. Under UCITS III, choice has become wider after 2003.
Deposits and Money Market instruments (MMIs) – Cash deposits with “credit institutions” (i.e. banks) can now be held as investment assets, together with MMIs. These might include treasury and local authority bills, certificates of deposit or commercial paper. Thus pure cash funds can now be UCITS.

Other mutual funds – UCITS have always been able to invest in other funds, although this was tightly restricted. UCITS III relaxed this restriction, with further ability to invest in other open-ended mutual funds where those are other UCITS or non-UCITS funds with UCITS-like traits. This has allowed the development of UCITS funds of funds.

Financial Derivative Instruments – under UCITS I, derivatives could only be used for hedging and EPM (i.e. to reduce risk or cost, or to replicate a position that could otherwise be achieved through investing in the underlying asset). With the advent of UCITS III, UCITS are able to use derivatives for investment purposes, using exchangetraded or over-the-counter (“OTC”) instruments, with some limitations. The underlying of a derivative must be:
• an eligible asset of the type mentioned above
• interest rates
• foreign exchange rates and currencies
• financial indices (e.g. S&P 500).
Physical short selling is not permitted. However, the same economic effect can be achieved and is allowed through the use of derivatives such as Contracts for Difference (“CFDs”). Firms must have systems and controls in place that can measure the derivative risk and provide an appropriate level of cover, which can mean that on the opposite side of the exposure there must be cash, a similar asset or balancing derivative giving an opposite exposure to a similar underlying asset to cover the original derivative exposure. It can also mean that some UCITS III funds may have high levels of gross exposure.

Ineligible assets – certain assets remains out of scope:
Real estate
Bank loans
Physical metals such as gold (although certain securities based on metals are permitted)
Commodities (although derivatives on financial indices such as commodity indices are eligible)

Risk spreading and concentration rules
A UCITS must be properly diversified. There are a number of different limits, all of them in place since UCITS I, but the best known is the 5/10/40 Rule. This states that a UCITS cannot invest more than 5% of its assets in securities issued by a single issuer. However, this limit can be increased up to 10% provided that where the 5% limit is exceeded, the exposure to these issuers, when added together, does not exceed 40% of the fund’s assets. There are also rules round the proportion of a company that a UCITS may hold in that it might gain significant influence over its management. Rules exist too regarding the amount of a company’s debt or non-voting shares that can be held.

Valuation of IRS using zero /discount curve.

What affects Swap Value?

From a valuation perspective swaps are not much different from customized notes and bonds. The fixed cash flows in a swap are akin to the interest payments on a high quality fixed rate note, while swap floating cash flows are like the interest payments on a floating rate note. Market variables that affect swap pricing include changes in the level of interest rates, changes in swap spreads, changes in the shape of the yield curve, and FX rates (for currency swaps). Key transaction-specific variables that affect swap valuation include notional principal amount and amortization, time to maturity, swap payment frequency, and floating rate reference index.

Mechanics of Swap Pricing

Measuring the current market value of an interest rate swap involves four distinct elements:

1.	Constructing a zero coupon* yield curve
2.	Extrapolating a forecast of future interest rates to establish the amount of each future floating rate cash flow
3.	Deriving discount factors to value each swap fixed and floating rate cash flow
4.	Discounting and present valuing all known (fixed) and forecasted (floating) swap cash flows.

While this may sound complicated, the curve building and discounting techniques are the same techniques used to establish the theoretical market value of any interest bearing security.

Constructing a Yield Curve

The first step in swap valuation is to build a yield curve from current cash deposit rates, eurodollar futures prices, treasury yields, and interest rate swap spreads. These known market rates are “hooked” together to form today’s coupon yield curve. The coupon curve is the raw material from which a zero coupon yield curve is constructed, usually using a method called “bootstrapping”. This involves deriving each new point on the curve from previously determined zero coupon points (hence the phrase, “bootstrapping”).

Zero rates are higher than coupon rates when the yield curve is positively sloped and lower when the curve is inverted. The gap is widest at the far end of the yield curve. When rates are low and the yield curve flat the difference between coupon and zero rates will be minimal, but when rates are high and the curve steep, the difference is significant.

Because the cash flow dates of the swap to be valued rarely exactly match the dates for which zero curve points have been developed, interpolation between data points is needed to solve the problem. While this sounds simple, some extremely complicated algorithms have been developed to minimize the errors that can arise from interpolation.

Forecasting Future Short-Term Rates

One half of the cash flows in a simple swap are floating rate. What makes the floating leg of the swap hard to price is the uncertainty of the forward rates—only today’s floating rate is known for certain. A forecast of future floating rates — a forward yield curve of short term interest rates—is needed before prospective floating rate cash flows can be generated. In fact, the forward curve is just an extension of the zero coupon yield curve; once the zero curve has been developed, it easily transforms into the forward curve needed to generate the swap’s floating rate cash flows.

Deriving Discount Factors

Discount factors, used to present value each swap cash flow, are developed as part of the process of bootstrapping the zero coupon yield curve. Like forward interest rates, discount factors are just a transformation of zero coupon rates. In fact, there is a simple formula for converting one to the other**.

Valuing the Swap

With all the calculations concluded, the only step remaining is to apply the discount factors to find the present value of fixed and floating swap cash flows. These values are then netted to determine the swap’s current market value. This value can be positive, zero, or negative, depending on how market interest rates have changed since the swap was created. For a floating to fixed swap, higher market rates will create a gain for the hedger, lower rates a loss. In the example below, a swap with a remaining term of 2 years is valued at a point when market interest rates have risen 1% across the yield curve from the time the swap was put into place.

Simple Rule of Thumb for estimating the sentivity of a Swap's Value to changes in Market interest rates results in Change in Value

While understanding the basics of swap valuation should make senior financial officers more comfortable with the balance sheet implications of the firm’s hedging activity, a quick and dirty way to estimate a hedge’s value and rate sensitivity can also prove useful.

A Simple Rule of Thumb for Estimating the Sensitivity of a Swap’s Value to Changes in Market Interest Rates While understanding the basics of swap valuation should make senior financial officers more comfortable with the balance sheet implications of the firm’s hedging activity, a quick and dirty way to estimate a hedge’s value and rate sensitivity can also prove useful. DV ’01—the change in dollar value of a swap for a one basis point change in market interest rates— is a simple measure for benchmarking how the value of an interest rate swap changes as interest rates change. However, because the DV ’01 changes as market rates go up and down and the shape of the yield curve changes, it can only be used to estimate the change in a swap’s value for small shifts in rates.

The chart below describes the DV ’01 for a $25 million interest rate swap with maturity between 2 and 10 years. These values are based on today’s yield curve (May, 1999). The values needed to estimate the potential gain or loss on a hedge include the actual fixed rate on the swap, the market fixed rate for a swap of equal remaining life, and the DV ’01 of the swap.

For example, ***Company ABC has a two month window in which to execute a five-year swap program covering $25 million of its bank debt. The company could hedge the debt today at a fixed swap rate of 5.90%, but it hopes that the market will improve over the next few weeks. Using the DV ’01 value, the company can estimate how much it stands to gain or lose from delaying the hedge. From the chart, the DV ’01 of a 5 year $25 million swap is $9,375. A 25 basis point change in rates (a not uncommon occurrence over a two month period), would trigger an opportunity gain or loss around $234,375 ($9,375 X 25 basis points). With an available estimate now of how much is at risk, the company can decide how confident it is in its interest rate forecast.

Summing Up

Hedgers have typically been concerned with the actual market value of interest rate swaps only at financial reporting dates or when considering the early termination of a hedge. However, as active hedge management increases and accounting ground rules change, understanding the basic concepts underlying swap valuation takes on more importance.

* Zero coupon rates are associated with instruments that pay no interest until maturity. The zero coupon curve is used in securities valuation because it requires no assumptions about reinvestment rates on intermediate cash flows.

** Discount factors can be derived from zero coupon rates using the formula 1/(1+r)^n where r is the periodic rate and n is the number of periods. Where zero rates are derived on a continuously compounded basis (the usual method), the formula becomes 1/e rt where e is the natural log, r is the zero rate and t is the term in years.

Dodd-Frank Act: Assessing the Regulations

The Dodd-Frank Wall Street Reform and Consumer Protection Act is commonly viewed as the most important piece of legislation in the US banking sector since the Great Depression of the 1930s. The act creates a number of institutional frameworks and reorganizes the federal regulatory system, but most of its impact will lie in the rules that stem from this federal reorganization.

The Act is also philosophically significant in that it goes some way in reversing a principle enshrined by the Gramm-Leach-Bliley Act of 1999, which holds at its core the ability for financial markets, especially on the wholesale side, to self-regulate and to function relatively unencumbered.

A representative measure of this philosophical bent is the appointment of a Financial Supervisory Oversight Council, FSOC, headed by the Secretary of the Treasury, which will be responsible for identifying potential systemic risks to the U.S. economy, partially on the basis of information it can obtain from the Office of Financial Research, which is discussed below, and to take whatever action is mandated, including lowering capital requirements in times of stress.

This is directly at odds with prevailing philosophy prior to the crisis, which would have viewed such an interventionist mandate as unnecessary and burdensome.

Beyond the creation of FSOC, which a priori is a relatively technical measure, the institutional and philosophical changes resulting from Dodd-Frank are likely to take some time to fully take effect, yet the reach of the law is certain to start being felt in the short term.

A case in point is the implementation of the Volcker Rule (named after former Fed chairman Paul Volcker), which aims to proscribe banks from proprietary trading, with its inherent moral hazards and risks, and limit its practice to dedicated actors such as hedge funds.

The proprietary trading model has created certain conflicts of interest for banks in that they hold information on clients’ flow that could be used to influence their own trading decisions – known as front-running. If the Volcker Rule is properly implemented, which will be a challenge in itself, it will be a positive development for the industry because it will bring banks back to the principle of serving their clients’ interests before their own.

The second major implication of Dodd-Frank is the movement of over-the-counter (OTC) securities trading to central counterparties (CCPs). Prior to Dodd-Frank, OTC instruments such as swaps were traded on a bilateral, one-off basis. In this context, the onus was on the client to seek optimal pricing from multiple liquidity providers and to take into account counterparty solvency, often through the use of credit valuation adjustment (CVA) or debt valuation adjustment (DVA).

This process could be onerous and time-consuming, especially as swaps tended to include confidential clauses, which made comparisons a significant practical challenge. A greater concern arising from the OTC trading model was that the failure of a significant trading ‘hub’ could cause untold damage to the market in general. These fears were realized to a devastating extent with the collapse of Lehman Brothers in 2008. The considerable losses of one firm created huge issues in netting, collateralization and rehypothecation for every other firm as all Lehman Brothers trades were unwound and the challenges in ascertaining the ownership and location of collateral among a multitude of participants became evident.

By ensuring that sufficient collateral is available to offset this default risk, the migration of a substantial portion of OTC trades to CCPs should minimize the risk of these events happening again. However, CCPs are not silver bullets; solvency risk is not obviated but simply moved further into the tail of the risk distribution as a multitude of individual counterparties are replaced by a theoretically smaller number of central counterparties. The failure of a CCP may therefore prove catastrophic, even more so than that of a “typical” bankruptcy in the pre- Dodd-Frank world. This puts a significant onus on the regulator to ensure that all CCPs are properly capitalized.

Another risk is that more and more CCPs may set up as private entities to take advantage of the mandatory migration to these models. This may create further market fragmentation and inefficiency in the allocation of collateral. This risk could be mitigated by agreements that allow cross-margining and cross-collateralization between CCPs. However, this would create potential liquidity risk in times of market stress should collateral not be readily available when and where it is required.

A little-noted but essential feature of Dodd-Frank is set to take place in July 2011, when banks will be required to offer their clients the ability to segregate their assets from those of the banks’. This rule is designed to make it simpler to disentangle clients’ assets from the banks in the case of a default, something that proved particularly troublesome in the case of the Lehman’s default. However, such a move is likely to raise the cost of trading derivatives because collateral will probably become less liquid.

Dodd-Frank also tackles a number of other issues, including the Orderly Liquidation Authority, which decrees that systemically important financial firms may supersede the bankruptcy code. This is again an attempt to respond to issues unearthed in the liquidation of Lehman Brothers. Beyond clarifying the process of liquidating a financial firm, Dodd-Frank aims to lessen the probability of such a failure by raising overall capital requirements and, most importantly, lessening such capital requirements in times of market stress. This approach is starkly at odds with Basel II-vintage regulation, which mechanically raised capital requirements pro-cyclically because these were steadfastly tied to Value at Risk (VaR).

Dodd-Frank’s capital requirements are established as minima for US-based institutions as well as US subsidiaries of foreign entities. Any superseding law has to comply with those minima. Further measures to lessen the risk of a significant financial firm (referred to as SIFIs or Systemically Important Financial Institutions) failing are to be subject to tighter regulation, and to Federal Reserve supervision, in addition to oversight by their “primary” regulators. Further constraints may include further trading restrictions or higher capital requirements.

All bank holding companies with assets exceeding $50 billion dollars automatically qualify, but it is expected that additional financial firms, such as insurance companies or hedge funds will join the ranks of the thusly-designated institutions. Firms will be designated by the Federal Reserve and the FSOC. Expect fierce lobbying from financial firms outside of the bank holding companies to escape the designation.

A measure starkly at odds with prevailing wisdom prior to the crisis of 2008/2009 is the creation of a potentially important institution, the Office of Financial Research (OFR). The OFR is a largely independent institution, hosted within the U.S. Treasury and mandated with monitoring firms’ financial exposures. Not only will the OFR disseminate this exposure information within the regulatory apparatus, it will also have the power to amend existing rules to reinforce its monitoring where warranted.

In effect, all designated financial institutions must develop adequate technology to transfer trade-level holdings information to the OFR. The OFR is then responsible for monitoring counterparty relationships within the firm and performing whichever risk calculations it deems relevant to inform policy making and enforcement.

How the OFR uses the information remains one of many open questions around the Dodd- Frank Act. Primarily it is meant to serve as a statistical office to the Financial Supervisory Oversight Council, as an aid in decision-making. The agency may beyond this become a rich source of information for academic work, particularly in financial economics. It is not known, however, how this data will be generated, transmitted, secured, anonymized, and treated, and made available, and to whom. It may remain captive to Treasury or may become a significant driver of risk and trading technology globally and thus may have consequential impact beyond pure risk technology. The OFR should thus be considered a powerful tool.

Current commercially available technology cannot comply with the breadth of the OFR mandate. Therefore this single part of Dodd-Frank is potentially far-reaching as it is likely to lead to the development of new technology to represent trades and monitor risk internally at a time when much of the financial sector takes a siloed approach. The OFR is thus likely to have a substantial impact on both future risk technology and more a-propos, on risk governance at large, since the two often seem to evolve in lockstep. The impact of the OFR at both a micro and macro prudential level, beyond its role within FSOC and government should not be underestimated.

The mandate of Dodd-Frank is arguably a worthy one. However, in some ways it is a framework rather than a complete body of law. Much of the implementation is not made explicit but left up to subsequent rule-making by the SEC, FDIC, Federal Reserve and CFTC, muddying the field and putting much of the efficacy of the law in the political realm, even if the law itself clarifies the purview of each of the regulators dramatically over the status-quo ante.

Rule-making, as opposed to just enforcement, is crucial in this process and is therefore a substantial onus on these agencies. However, because these agencies rely on congressional appropriations, much of their efficacy can be hampered by poor oversight or cuts in their funding. Recent attempts at delaying the nomination of a chair to the Consumer Financial Protection Bureau (CFPB) is a case in point.

Even assuming that the law is fully funded, which is difficult to conceive in the current budgetary climate, deadlines are likely to be missed. The CFTC, for instance, has announced that the July 2011 deadline for rules affecting the regulation of swaps dealers will not be respected.

A further threat to Dodd-Frank’s integrity comes from the possibility that it will be diluted to allow for regulatory arbitrage. Such arbitrage was a key enabler in the failure of AIG, as the firm was structured to fall within the purview of the Office of Thrift Supervision, an agency generally mandated with overseeing small enterprises and not large, leveraged institutions.

Proposed exemptions to the Dodd-Frank Act also create a risk of regulatory arbitrage. For example, the U.S. Treasury recently submitted a formal proposal to exempt a large class of FX swaps from central clearing. Arguments have been put forward to justify this exemption, including the existence of well-established payment systems in the FX world, the relatively short average maturity of such trades, and the great liquidity of FX exchange mechanisms globally. However, the existence of such a large loophole in the regulation of swaps creates an opportunity for regulatory arbitrage and thus a situation potentially worse than the current status quo. One can easily conceive of mechanisms to transform ordinary interest rate swaps into FX swaps by hedging away currency exposure, creating a parallel market outside of the purview of the CCP. This issue was most recently pointed out by Darrell Duffie, a noted financial economist and derivatives expert.

A further exemption to central clearing affects so-called end users of derivatives: i.e. nonfinancial firms. This exemption primarily relieves such firms from having to post collateral in derivatives trades because they are most often entered into not on a speculative basis but to hedge an underlying exposure. Such exemptions are problematic because the definition of an end user is unclear and therefore once again we see opportunities for regulatory arbitrage. For example, it is not clear what can prevent an ostensibly non-financial company from creating a trading arm that is not recognized as a bona-fide financial company, thus benefitting from regulatory relief.

The Volcker rule, perhaps the centrepiece of Dodd-Frank, is also subject to regulatory uncertainty because in practice, proprietary and non-proprietary trading can be difficult to distinguish. Providing liquidity to its clients may require a bank maintain exposures on its own books for long periods of time. When does such a book become proprietary? Arguably, in a one-off case a regulator could make a determination, but it is difficult to establish a hard-and fast rule for these situations.

Although the Dodd-Frank Act is complex, imperfect and subject to the same law of unexpected and unintended consequences that all human endeavours are, it is nonetheless likely to result in a financial sector that is less prone to systematic crises. Let us not forget that no serious financial crisis occurred between the 1930s and 1987, and thereafter such crises have had the habit of rearing their ugly heads every three to four years, in different guises. The key is to regulate the financial sector consistently without depriving the economy of the capital that it requires to function effectively.

Presentation of and policies for Fund accounting in India

Presentation of accounts:

Mutual funds , should prepare schemewise balance sheet as per Annexure IA and IB of Eleventh Schedule of SEBI (Mutual Funds) Regulations 1996. As per regulation 54, every mutual fund or asset management company shall prepare in respect of each financial year an annual report and annual statement of accounts of the schemes and funds.

The balance sheet shall give schemewise particulars of its assets and liabilities and shall contain particulars as per Eleventh Schedule. It should also disclose accounting policies relating to valuation of investments and other important items. Under each type of investment, the aggregate carrying value and market value of non-performing investments shall be disclosed. It should also indicate the extent of provision made in revenue account for the depreciation /loss in the value of non -performing investments. It shall also disclose per unit Net Asset Value (NAV) as at the end of accounting year. Previous year figures should also be given against each item.

It should also indicate the appropriation of surplus by way of transfer to reserves and dividend distributed. It should also contain -

• Provision for aggregate value of doubtful deposits, debts and outstanding and Accrued income.
• Profit or loss in sale and redemption of investment may be shown on a net basis.
• Custodian and registrar fees.
• Total income and expenditure expressed as a percentage of average net assets, calculated on a weekly basis.

Schemewise balance sheet normally contains the information under following groups -

Asset side - Investments, Deposits, Other Current Assets, Fixed Assets, Deferred revenue expenditure

Liability side - Unit capital, Reserves and surpluses, Loans, Current liabilities,

Accounting Policies:

Accounting policies of mutual fund schemes are somewhat different from those of an industrial concern. Ninth schedule to SEBI (Mutual Fund) Regulations 1996 deal with accounting policies and standards to be adopted by a mutual fund.

The accounting policies generally cover the following areas -

1. Basis of Accounting
The fund maintain its books of account on an accrual basis.

2. Portfolio Valuation
Investment are stated at market/fair value at the balance sheet date/date of determination. In valuing the scheme's investments.

(i) Securities listed on a recognized stock exchange are valued at the last quoted price on the principal exchange on which the security is traded.

(ii) Money market instruments are valued at fair value as determined in good faith by Asset Management Company (AMC)

3. Securities Transactions
Investment securities transactions are accounted for on a trade date basis. The scheme uses the average cost method for determining the realized gain or loss on sale of investments.

4. Investment Income
Dividend and interest income are recorded on an accrual basis.

5. Deferred Revenue Expenditure
Initial issue costs comprise those costs directly associated with the issue of units of the scheme and include brokerage/incentive fees on issue of units, advertising and marketing costs, registrar fees and expenses and printing and despatch cost, which are being amortized over a period of ten financial years.

6. Dividend Equalization Reserve
The net distributable income relating to units issued/repurchased is transferred from/to Dividend Equalization Reserve for Dividend Plan for determining the net surplus/deficit transferred to /from Unit Premium Reserve.

The Scheme does not intend to declare dividends or make any other distribution in respect of units held under the Growth Plan and accordingly has not accounted for Dividend Equalization in respect of this plan during the year.

7. Unit Premium Reserve
Upon issue and redemption of units, the net premium or discount to face value of units is adjusted against the Unit Premium Reserve of the Scheme, after an appropriate portion of the issue proceeds and redemption payout is credited or debited respectively to the Dividend Equalization Reserve.

The Unit Premium Reserve is available for dividend distribution except to the extent it is presented by unrealized net appreciation in value of investments and deferred revenue expenditure.

8. Agent's Commission
Agents commission expenses are not considered as distribution charges.

Unit trusts Vs Oeics

Unit trusts and open ended investment companies (Oeics) are forms of shared investments, or funds, that allow investor to pool his money with thousands of other people and invest in world stock markets. Unit trusts have proved incredibly popular because investors money is invested in a broad spread of shares and their risk is reduced. But they are gradually being replaced by their modern equivalent, the Oeic.

Oeics (pronounced 'oiks') were first sold to UK investors in 1997. The FSA's(Finan Services Authority) rules governing which types of fund can convert to Oeics were relaxed in 2001 and since then, the majority of fund management groups have converted their unit trusts to Oeics or launched these funds.

Investors can invest in a unit trusts and Oeics on monthly or lump sum, which means it can be a relatively painless way to get a foothold in the stock market. Typically you they pay an initial charge of 5% to 6% and an annual management charge of between 1% and 1.75%.

The differences

Unit trusts and Oeics are both open-ended investments, which means that investors can freely buy and sell shares in the fund, which then grows or shrinks accordingly. It means the value of the shares they own in an Oeic, or units in a unit trust, always reflects the value of the fund's assets.

But there are a few key differences…

Pricing: When investing in unit trusts, you buy units at the offer price and sell at the lower bid price. The difference in the two prices is known as the spread. To make a return on your investment the bid price must rise above the offer before you sell the units. An Oeic fund has a single price, directly linked to the value of the fund's underlying investments. All shares are bought and sold at this single price, so there is no need to calculate the spread. The Oeic has been described as a 'what you see is what you get product'.

Flexibility: An Oeic fund can offer different types of share or sub fund to suit different types of investor, so private individuals can invest in the same funds as large institutions and pension fund managers. The expertise of different fund management teams can be combined to benefit both large and small investors, while streamlining the administration and management costs of the fund. Clients receive less paperwork, as each Oeic will produce one report and accounts for all sub funds, instead of separate reports for each fund.

Complexity: In legal terms, unit trusts are much more complex. In fact, this is the main reason for their rapid conversion to Oeics. Unit trusts entitle an investor to participate in the assets of the trust, without actually owning those assets. Investors in an Oeic, meanwhile, buy shares in that investment company. The ownership of unit trusts is divided into units. These rise and fall in value in line with the share price performance of the fund's underlying assets.

Management: With unit trusts, the fund's assets are protected by an independent trustee and are managed by a fund manager. Oeics are protected by an independent depository and managed by an authorised corporate director.

Charges: Unit trusts and Oeics usually have an up-front buying charge, typically 3%-5%, and an annual management fee of between 0.5% and 1.5%. It is possible to reduce these charges by investing through a discount broker or fund supermarket, but this means acting without financial advice. Charges on Oeics are pretty transparent. Any initial charge is shown as a separate item on your transaction statement - so the whole transaction is clear and easy to understand.

Oeics are cheaper to run than unit trusts because they can contain a number of sub-funds, rather than each unit trust needing to be a separate entity. This cuts down on the costs of administration. In theory, this should lead to lower charges for investors.

SWING PRICE

Type of funds as per pricing

Funds may be either single price funds or dual price funds. Dual price funds publish two NAV's one for subscription and another for redemption. Since single price have only one NAV, so huge incoming subscriptions or redemptions can impact exixting unit holders NAV if transaction cost is charged to fund.

Introducing swing pricing

When an investor buys or sells shares in an investment fund, the fund incurs dealing costs. Absent a mechanism protecting the interests of other shareholders, these costs are shared across all of the fund’s shareholders. As a result, the activity of one shareholder can be to the detriment of other investors in the fund. Swing pricing is a technique designed to reduce the negative impact of subscriptions and redemptions on “non-trading” investors in a fund. This approach to pricing is being used by a growing number of fund managers.

How does swing pricing work?

Conceptually, in some respects swing pricing is similar to dual-priced funds that require investors to deal on a bid-offer basis, except that swing pricing is used for single-priced funds. With swing pricing, a single price is issued, and all clients buy and sell at this price. To calculate the dealing price, the funds’ administrator calculates the net asset value (NAV) for the fund before consideration of capital activity – subscriptions and redemptions – and then adjusts (“swings”) the NAV by a pre-determined amount. The direction of the swing depends on whether the fund is experiencing net inflows or net outflows on the dealing day, while the magnitude of the swing is based on pre-determined estimates of the average trading costs in the asset class.

• If the fund is experiencing net inflows, the NAV is adjusted upwards.

• If the day’s dealings generate a net outflow, the NAV is adjusted downwards.

These adjustments serve to insulate non-dealing shareholders from the trading costs triggered by the dealing shareholders. Swing pricing can be used on either a full or partial basis. With full swinging, the

price swings every day regardless of the size of the net capital flows. With partial swinging, the price swings only if the net capital flows exceed a pre-determined threshold.

Implications of swing pricing for investors

One of the key principles of swing pricing is that any investor transacting at a volume that would materially impact other fund investors should bear the costs of their trading. The nature of the partial swing pricing mechanism, however, means that if the net trading in the fund does not meet the threshold of materiality, no swing occurs as trading costs do not have a material impact on other shareholders.

The mechanics: determining swing magnitude and thresholds

The extent to which prices are swung depends on the costs of trading in the particular asset class. To determine the extent of price swing for a particular fund, investment team calculates a swing adjustment factor based on broker commissions, taxes and other trading-related charges, and foreign exchange costs where relevant. The investment team then makes a recommendation to Pricing Committee, who makes the final determination. The Committee also sets the threshold of net subscriptions or redemptions which will trigger price swinging. Swing adjustment factors and thresholds are reviewed on a regular basis. Common with industry best practice to reduce the chance that some investors may try to “game” their trading activity in the funds, it is not our intention to notify investors in advance if the thresholds or swing factors change. However, details are available on request.

Other implications of swing pricing

Investors should be aware of the impact of price swinging on a number of aspects of a fund’s administration and performance:

• Performance is measured and reported using swung prices. Since it is possible that prices could have swung on either or both the initial or ending date over a period in which performance is being measured, it is possible that the returns of the fund are influenced by trading activity in the fund, as well as the

performance of the fund’s investments.

• Price swinging can increase the variability of the fund’s returns, causing the fund to appear to have slightly higher risk levels than would be expected based on the underlying holdings. However, as price swinging benefits a fund’s long term investors, best practice is to measure performance based on the swung

price.

• Performance-related fees are not based on swung prices. Performance fees are intended to remunerate managers based on the success of their investment decisions, and should not be influenced by fund investors’ transaction activity. Also, as performance fees are crystallised on specific

dates, if the fee was based on a swung price the amount of the fee could be materially distorted. Therefore, performance fees are calculated using unswung (and un-published) prices. This process is, of course, monitored carefully by the funds’ auditors.

Valuation of Debt Securities in India

Debt funds and Valuation Debt funds like any other asset are driven by the same basic tenet. A fair valuation is one that has to take into account market realities at prices that are market driven. A debt fund at any given point in time holds different debt instruments. Thus the NAV, which reflects the value of all the underlying assets in the portfolio, to be fair and correct should take into account the market price of each of the instruments that comprise the portfolio. This process where each asset is valued at current market prices is called "Marking to Market". Marking to market has become very essential as it indicates the financial health of a portfolio. To a large extent this procedure indicates the amount of risk the fund carries. Essentially any portfolio can either have liquid or illiquid securities. While valuing liquid securities is a no-brainer as the prices can be taken from the exchanges, valuation does assume great significance when it comes to valuing illiquid securities. The problem of valuation gets compounded when it comes to valuing debt securities in India. The absence of a broad based market resulted that trades were concentrated around a few securities. A Debt fund at any given point of time can hold three different types of assets. • Government securities • Corporate debentures with a residual maturity of more than 6 months • Money market instruments and corporate debentures with a residual maturity of less than 6 months Different categories of assets are marked to market in different ways depending mainly on the liquidity of the asset. As a thumb rule, higher the credit, higher the liquidity. Consequently the most liquid among debt instruments are the securities issued by the Government as the risk is sovereign. Bond Valuation The value of a bond can be defined as the present value of the future cash flows discounted at an appropriate rate. The cash flows expected from the bond are made up of a) Coupon payments and b) Redemption of Principal. Bond Price= C/(1+i) + C/(1+I)2 + C/(1+I)3+ …..+ C/(1+I)n +M/(1+I)n Where C = Coupon Payments M = Redemption Amount N = Number of Coupon Payments i = Discounting rate or the yield of the bond. Yield or the Discounting Rate The price of the bond depends significantly on the rate which is used to discount the future cash flows. To get a uniform pricing for various debt instruments a matrix known as the CRISIL Bond Valuer maintained and developed by CRISIL and approved by SEBI is used for bond valuation. Valuing Government Securities Government securities are marked to market on a daily basis. Since the G Sec market in our country is the most liquid segment of our debt markets, it is possible to get a price of G-Secs on any given day. Hence the G-sec portion of the portfolio is marked to market on a daily basis at the last traded price. Earlier fund houses used differing sources ranging from NSE to the RBI's SGL. However circa March 2002 it is mandatory for all fund houses to use prices provided by CRISIL. CRISIL uses the Spread over Benchmark concept while valuing non traded government securities. Any event like an interest rate change triggers the rise or fall of government securities. But the impact is not similar across all G-Secs. The impact depends on a host of factors chiefly duration, coupon rate and the liquidity level of the security. Benchmarks are set up for different tenor buckets e.g. securities with 1-2 years outstanding maturity, 2-3 years 3-4 years and so on. For each of these tenor buckets benchmarks are identified based on the turnover, frequency of trading in the secondary market. These prices are provided by CRISIL on a daily basis. Valuing Corporate Securities Debt securities like bonds, debentures are valued differently depending on whether they are traded or non- traded and additionally depending on the value of the traded securities. The valuation for the traded securities of traded value in excess of Rs 5 crores is done based on the YTM. The YTM is calculated on the last traded price and is maintained till the next CRISIL matrix. Thinly traded securities and non-traded securities valued at more Rs 5 crores and with a residual maturity of more than 182 days are valued using the Crisil Bond Valuer. The Crisil Bond Valuer uses a benchmark YTM built using GOI Sec as the base for each duration bucket. There are 7 duration buckets starting from 0.5 to > 6 years. CRISIL provides a matrix of yields across various duration buckets (the most row in the table below) and rating categories (the leftmost column) on a weekly basis. Here is how it works. When deciding the price of a corporate debenture the key is to determine the yield of the debenture. CRISIL arrives at this table after taking into account various macro and micro economic factors and the repaying capacity. Once the yield is known the price computation is easily accomplished.

23/10/2002 Average 0.5-1 1.0-2.0 2.0-3.0 3.0-4.0 4.0-5.0 5.0-6.0 >6.0 Gilt 6.46% 5.85% 6.01% 6.17% 6.31% 6.54% 7.05% 7.28% AAA 7.21% 0.75% 0.87% 0.83% 0.80% 0.78% 0.59% 0.64% AA+ 7.58% 1.11% 1.16% 1.08% 1.05% 1.14% 1.11% 1.19% AA 7.95% 1.45% 1.43% 1.40% 1.40% 1.63% 1.54% 1.62% AA- 8.47% 1.95% 1.89% 1.86% 1.89% 2.15% 2.10% 2.26% A+ 9.15% 2.60% 2.62% 2.62% 2.65% 2.84% 2.73% 2.78% A 9.73% 3.00% 3.18% 3.22% 3.30% 3.52% 3.39% 3.33% A- 10.66% 3.70% 4.16% 4.31% 4.28% 4.41% 4.31% 4.28% BBB+ 11.59% 4.47% 5.03% 5.22% 5.25% 5.38% 5.28% 5.28%

If you buy a bond at face value, its rate of return, or yield, is just the coupon rate. However, after they're first issued, bonds rarely sell for exactly face value. The yield differs from the coupon. While the coupon rate is the stated interest rate offered by the debenture and is always calculated on the principal value, the yield is often the return that one would get considering the future interest flows and the prevailing interest rate scenario. To give an example using the above matrix say a corporate debenture issued by a Corporate rated AA+ with a residual duration of 2.5 years would be calculated as under. The yield of this will be the benchmark yield plus the markup depending on the bucket the debenture falls into. Therefore yield used for valuation would be 6.17(benchmark)+1.08(spread) =7.25%. All corporate debentures that fall in a particular slot within the matrix are valued at rates specified by CRISIL matrix. Additionally the fund house is at a liberty to add a discretionary discount/premium upto +100/-50 bps for rated paper with duration upto 2 yrs and upto +75/-25 bps for rated paper with duration over 2 yrs. In case of an unrated paper the fund house needs to assign an internal credit rating which is then used for valuation. In this case the yield would be marked up by adding 50 basis points for securities having a duration upto two years and by 25 basis points for securities of duration higher than two years. Valuing Money Market instruments Money market instruments and corporate debentures with residual maturity of less than 6 months are valued by amortization. The difference between the face value and the cost is amortised over the life of the instrument. SEBI has provided that all money market instruments and corporate debentures maturing within 6 months have to be valued on a cost plus accrual basis instead of marking to market. So the next time you decide to invest in a fund you know what to look out for. Valuation therefore is a critical element of the entire funds management business. It takes time and hence funds have cut-off times so that all transactions for the day can be accounted for the days NAV. Any transaction that gets missed out implies that the resulting NAV is not the accurate NAV. It is for this reason that AMFI along with SEBI has started getting stricter on adherence to cut-off times.