Credit Default Swaps

What Is a Credit Default Swap (CDS), and How Does It Work?


What is in the 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, the regulator said on Thursday.

What is Credit Default Swap ?

• A credit default swap is a financial swap agreement that the seller of the CDS will compensate

the buyer in the event of a debt default or other credit event. That is, the seller of the CDS

insures the buyer against some reference asset defaulting.


 Alternative Investment Funds (AIFs)

• Investment schemes that allocate their funds to financial instruments other than traditional

investment options are called alternative investment funds. They include angel funds,

commodities, real estate, venture capital, private equity, etc.

• Alternative Investment Fund or AIF means any fund established or incorporated in India which

is a privately pooled investment vehicle which collects funds from sophisticated investors,

whether Indian or foreign, for investing it in accordance with a defined investment policy for

the benefit of its investors.

• AIF does not include funds covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI

(Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to

regulate fund management activities.

• Benefits :

▪ Profitable returns

▪ Risk hedging and protection against market volatility

▪ Reduced dependence on foreign capital

▪ Helps in portfolio diversification


AIF : Categories

1. Category 1 : In Category 1, you will find Alternate Investment Funds that invest in start-ups,

SMEs and new economically viable corporations that have high growth potential. Example –

Infrastructure Funds, Venture Capital Funds, Angel Funds, Social Venture Funds.

2. Category 2 : AIFs which do not fall in Category I and III and which do not undertake leverage

or borrowing other than to meet day-to-day operational requirements and as permitted in

the SEBI (Alternative Investment Funds) Regulations, 2012. Example – Debt Funds, Private

Equity Funds, Fund of Funds.

3. Category 3 : AIFs which employ diverse or complex trading strategies and may employ

leverage including through investment in listed or unlisted derivatives. Example – Hedge

Funds, Private Investment in Public Equity(PIPE) Fund.


 Different AIFs

• Infrastructure Funds : These funding schemes primarily invest in companies that are engaged

in infrastructural works like constructing railroads, airports, ports etc.

• Venture Capital Funds : Venture capital funds put their money into promising entrepreneurial

businesses that have huge capital requirements. High net-worth individuals who have a high[1]risk high return policy usually invest in VCF.

• Angel Funds : This type of AIF generally invests in new start-ups that do not receive

investments from Venture capital funds. Each angel fund investor generally allocates

minimum funding of Rs.25 lakh.

• Social Venture Funds : Social venture fund schemes put their money in businesses that take

part in philanthropic activities. They help people improve their standards of living and also

provide good returns to their investors.

• Debt Funds : These funds invest in debt securities of unlisted companies that follow good

corporate governance models and have decent growth potential.

• Fund of Funds : Funds of funds are schemes that put their money in other Alternative

Investment Funds.

Private Equity Funds : Private equity funds invest in unlisted private businesses that face

difficulty in raising capital by issuing equity and debt instruments.