Introduction of credit derivatives in India is a watershed development for bank's credit risk management practices. It will fundamentally change the way banks price, manage, transact, originate, distribute and account for credit risk. Banks can use the credit derivatives to diversify their portfolios of loans and other risky assets. Credit derivatives are contracts that transfer an asset's risk and return from one counter party to another without transferring ownership of the underlying assets. The three major types of credit derivatives are default swaps, total rate of return swaps and credit spread put options.

Two major uses of credit derivatives, that attract the market participants to purchase protection against credit risk, are credit line management and regulatory arbitrage. Factors that motivate the market participants to sell protection against credit risk are funding arbitrage and product restructuring.

Credit line management is relevant for dealing with a situation where a bank is over-concentrated in loans to companies in a specific sector of the economy. Though selling the loan in secondary market or origination of loans in non-traditional sectors can transfer the concentration risk, credit derivatives can be used effectively and efficiently to mitigate the concentration risk. For example, if the bank sells the loan in the secondary market, it will damage the valuable relationship with the customer. The bank can also face new risks while diversifying its loan portfolio in non-traditional sector. By using the credit derivative, a bank can diversify its loan portfolio more cost effectively and maintain the valuable relationship with customers. Credit derivatives can also be used for regulatory arbitrage under Basel covenants.

Credit Derivatives, India, risk management practices, banks price, credit risk, credit derivatives, swaps, options, Basel covenants, non-traditional sectors, economy, Credit line management, product restructuring, funding arbitrage, credit risk, over-concentrated, asset's risk, banks price, manage, transact, originate, distribute, customers.