Deriv Change Leverage India 2023

Leverage Inherent in a Bank’s Derivatives Position

Given the fierce competition for capital in this country, banks are rethinking their derivatives portfolios to include more risky assets. Leverage is an inevitable consequence of this shift but can be managed effectively through an integrated derivation and risk management strategy. This consists of measures that attract both regulators and investors' attention; thus minimizing financial risks related to interest rate, liquidity and credit exposures.

Leverage Inherent in a Bank’s Credit Derivatives Position

Credit default swaps (CDSs) are one of the world's most widely-used credit derivative products. They operate over-the-counter (OTC), enabling synthetic trades in a credit asset. CDSs can be traded by anyone with an exposure to credit risk - usually banks and financial institutions but also Foreign Portfolio Investors (FPIs)).

Bank credit derivative positions carry leverage which depends on the amount of exposure to a reference obligation. If that obligation's fair value drops below a pre-determined level, then any written credit derivative could be reduced by that loss; this typically happens when bond markets go down, which is an extremely common occurrence.

Accounting-wise, CDS contract risk weights are determined by market participant capital adequacy requirements that in turn depend on prudential norms and regulations issued by sectorial regulators. For instance, NBFCs must maintain capital charge on 20% of exposure when corporate bonds are held under current category; whereas, for permanent category bonds where there is no mismatch between them and CDS, full capital protection is allowed.

Leverage Inherent in a Bank’s Equity Derivatives Position

A bank's equity derivatives position is largely determined by its holding of securities as an investment. These may include equity or debt issued by a company. The bank could hold these as investments to generate interest on the cash flow derived from them, or invest directly in the security if it anticipates an increase in fair value over time.

As such, the leverage inherent in a bank's equity derivatives position can be substantial. In India, banks typically calculate their leverage from multiplying their equity holdings by their credit exposure to underlying stocks - this yields a leverage ratio which acts as an anchor for risk-based capital metrics.

Sources familiar with the regulator's thinking indicate Indian hedge funds will be allowed a minimum leverage of two to three times. This requirement is designed to ensure local hedge fund operations don't become overtaxed. While this decision may disappoint some fund managers who had anticipated higher leverage levels, it could potentially spur an resurgence in Indian hedge fund activity.

Leverage Inherent in a Bank’s Interest Rate Derivatives Position

Bank interest rate derivatives can be a mysterious asset class, but when properly used by investors, can have an immense effect on their portfolio's profitability. As its name suggests, this class can be somewhat of a mystery to investors of all levels. Even experienced professionals may struggle with making timely risk management decisions in such an uncharted territory. No deriv change of order is likely in the cards, but managing hedging strategies correctly can be an effective way to mitigate risk without sacrificing performance. The most crucial element of any interest rate derivatives strategy is having a thorough understanding of the risks and associated costs that come with taking such positions - which may vary significantly depending on a bank's objectives and capabilities.