Page 159 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes The underlying assets on which credit derivatives can be written could be either the
rupee-denominated assets or foreign currency-denominated assets originated by domestic
entities and having resident entities as the obligors. In case of foreign currency assets, the
premiums and the credit event payments can be denominated in foreign currency.
In such cases, the participants in the transactions can only be such banks and financial
institutions who are authorised to deal in foreign exchange.
The credit derivative should conform to the following minimum criteria, i.e., it should be
direct, explicit, irrevocable and unconditional.
The credit protection must represent a direct claim on the protection provider and must be
linked to specific exposures, so that the extent of the cover is clearly defined and
incontrovertible.
Other than a protection purchaser's non-payment of money due in respect of the credit
protection contract, there must be no clause in the contract that would allow the protection
provider unilaterally to cancel the credit cover.
There should be no clause in the protection contract that could prevent the protection
provider from being obliged to pay out in a timely manner in the event that the original
obligor fails to make the payments due.

Source: http://www.thehindubusinessline.in

Self Assessment

Fill in the blanks:
11. ………….pricing of loans is a fundamental tenet of risk management.

12. ……………….is an effective tool for constantly evaluating the quality of loan book and to
bring about qualitative improvements in credit administration.
13. The pricing of loans is normally linked to risk rating or …………….. .

11.5 Weather and Energy Derivatives

Weather derivatives are financial instruments that can be used by organisations or individuals
as part of a risk management strategy to reduce risk associated with adverse or unexpected
weather conditions. The difference from other derivatives is that the underlying asset (rain/
temperature/snow) has no direct value to price the weather derivative. Farmers can use weather
derivatives to hedge against poor harvests caused by drought or frost, theme parks may want to
insure against rainy weekends during peak summer seasons, and gas and power companies
may use Heating Degree Days (HDD) or Cooling Degree Days (CDD) contracts to smooth
earnings.

Heating degree days are one of the most common types of weather derivative. Typical terms for
an HDD contract would be like: for the November to March period, for each day where the
temperature falls below 18 degrees Celsius keep a cumulative count. Depending upon whether
the option is a put option or a call option, pay out a set amount per heating degree day that the
actual count differs from the strike.
The first weather derivative deal was in July 1996 when Aquila Energy structured a dual-
commodity hedge for Consolidated Edison Co. The transaction involved ConEd's purchase of
electric power from Aquila for the month of August. The price of the power was agreed to, but
a weather clause was imbedded into the contract. This clause stipulated that Aquila would pay

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