Derivatives, Credit Derivatives and ALM Decisions - Article

Introduction

Asset-Liability Management (ALM) deals with mismatches in a bank’s:

• liquidity;

• interest-rate structure;

• maturity profile;

• currencies;

• funding sources; and

• balance-sheet risks.

Some mismatches can be changed by altering the underlying balance sheet.

For example, a bank may:

• raise longer-term deposits;

• reduce long-duration investments;

• change loan pricing; or

• modify its funding mix.

But changing the underlying asset or liability may be:

• expensive;

• slow;

• operationally difficult; or

• commercially undesirable.

Derivatives provide another route.

They can change the economic risk exposure without necessarily cancelling the original asset or liability.

The current 2026 IIBF BFM syllabus specifically covers Use of derivatives in ALM, Credit risks and Credit Derivatives under Module C – Treasury and Asset-Liability Management.

For CAIIB, remember:

ALM identifies the unwanted risk → Treasury selects the appropriate hedge → Risk function measures the residual risk → ALCO reviews the resulting balance-sheet position.

Learning Objectives

After studying this topic, you should be able to:

• explain how derivatives support ALM;

• distinguish market-risk derivatives from credit derivatives;

• understand CDS protection buyer and protection seller positions;

• explain how TRS transfers the economic performance of a credit asset;

• analyse derivative-based ALM cases;

• identify basis, counterparty, liquidity and over-hedging risks; and

• apply the current RBI credit-derivative framework to important CAIIB situations.

Why ALM Uses Derivatives

Suppose a bank has a five-year fixed-rate asset funded by floating-rate liabilities.

If rates rise:

• liability cost may increase;

• asset income remains fixed;

• Net Interest Income may fall.

The bank could sell or restructure the asset.

Alternatively, an appropriate derivative may change the economic interest-rate profile.

Similarly, a bank holding a corporate bond may want to retain the investment but reduce its credit risk.

A credit derivative can potentially transfer part of that credit risk without requiring immediate sale of the bond.

Main Derivatives Used in ALM

The product must match the risk.

A credit derivative should not be selected merely because the bank has an interest-rate mismatch.

Market-Risk Derivative vs Credit Derivative

A normal interest-rate derivative transfers interest-rate risk.

A currency derivative transfers foreign-exchange risk.

A credit derivative derives its value from the credit risk of an underlying debt instrument or an index of debt instruments under RBI’s current definition.

Therefore:

IRS → Interest-rate risk

Currency Swap → Currency and rate risk

CDS/TRS → Credit-related exposure

Current RBI Credit-Derivative Framework

A major current-position point is important for CAIIB.

RBI issued the Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2026 on June 25, 2026. It came into force immediately and superseded the 2022 Credit Derivatives Directions. The 2026 framework applies to credit derivatives undertaken in OTC markets and on recognised stock exchanges in India.

The 2026 framework expressly covers:

• Credit Default Swaps (CDS);

• Total Return Swaps (TRS);

• CDS on eligible credit indices; and

• exchange-traded futures on eligible credit indices.

What Is a Credit Default Swap?

A Credit Default Swap (CDS) transfers specified credit risk from one party to another.

There are two main parties:

Protection Buyer

The protection buyer pays a periodic premium.

In return, it receives protection if the specified credit event occurs according to the contract.

Protection Seller

The protection seller receives the premium.

In return, it assumes the obligation to make the contractual credit-event payment if the specified event occurs.

RBI’s current 2026 Directions define CDS in substantially this manner.

The basic risk transfer is:

Credit Exposure Held by Bank

↓

Bank Buys CDS Protection

↓

Credit Risk Transferred Partly/Wholly to Protection Seller, subject to contract

Case 1: Bank Holds Corporate Bond but Wants to Reduce Default Risk

A bank holds a corporate bond.

ALCO is comfortable with:

• the bond’s maturity;

• interest-rate exposure; and

• liquidity position.

However, the issuer’s credit outlook is weakening.

The bank does not want to sell the bond immediately.

Possible ALM Decision

The bank may consider buying eligible CDS protection.

Economic Effect

The bank:

• continues to hold the bond;

• continues to receive bond cash flows;

• pays CDS premium; and

• receives contractual protection against specified credit events.

CAIIB Learning

A CDS can allow the bank to separate:

Ownership of debt instrument

from

Credit-risk exposure

But the hedge is effective only to the extent that the:

• reference obligation;

• notional;

• tenor;

• credit-event definition; and

• settlement structure

properly match the underlying exposure.

Case 2: Bank Buys CDS but Bond Interest-Rate Risk Remains

A bank buys CDS protection on a corporate bond.

Management concludes that the bond is now risk-free.

Analysis

Incorrect.

CDS primarily addresses the contractual credit risk covered by the protection.

The bond can still lose value because:

• general interest rates rise;

• market liquidity deteriorates;

• basis changes;

• the hedge becomes imperfect; or

• the protection seller weakens.

CAIIB Learning

Credit hedge ≠ interest-rate hedge

ALM may need separate tools for different risks.

Case 3: Protection Buyer Has Larger CDS than Underlying Exposure

A user holds ₹100 crore of eligible debt exposure but buys ₹150 crore CDS protection and describes the entire transaction as a hedge.

Analysis

That creates an over-hedged position.

Under RBI’s current 2026 Directions, where a credit derivative is undertaken for hedging, the user must have the relevant underlying exposure, and the protection notional cannot exceed the face value of the qualifying reference exposure held.

CAIIB Learning

A genuine hedge should match the exposure.

₹100 crore risk does not require ₹150 crore hedge merely because additional protection is available.

Case 4: CDS Tenor Extends Beyond the Underlying Bond

A bank holds a debt instrument maturing in three years but buys a much longer CDS and treats the complete position as a hedge.

Analysis

For transactions undertaken for hedging under the current RBI framework, the credit derivative cannot have a tenor later than the permitted maturity relationship with the underlying reference exposure.

CAIIB Learning

Check both:

Amount Match

and

Tenor Match

A correct reference entity alone does not create a correct hedge.

Case 5: Bank Sells the Bond but Keeps the Hedge

A bank buys CDS protection against a bond.

Later, it sells the entire bond but continues holding the CDS indefinitely.

Analysis

The original underlying exposure has disappeared.

Under the current 2026 RBI Directions, a user undertaking a credit derivative for hedging must exit the credit-derivative position within one month from the date it ceases to have the underlying exposure.

CAIIB Learning

A hedge should not silently become an unrelated speculative position after the underlying exposure disappears.

Case 6: Individual Customer Wants an OTC CDS

An individual approaches a bank and asks to buy CDS protection on a corporate bond.

Analysis

Under RBI’s current 2026 Directions, a market-maker shall not offer CDS contracts to an individual.

CAIIB Learning

Economic logic alone is not enough.

Every derivative decision also requires checking:

Participant Eligibility + Product Permission + Purpose

Credit Event

A CDS settlement occurs only when a contractual credit event happens.

RBI defines a credit event as a pre-defined event in the credit-derivative contract that triggers settlement.

Therefore:

Fall in bond price ≠ automatically CDS credit event

A bond can lose market value because:

• interest rates increased;

• liquidity declined; or

• credit spreads widened

without the contractual credit event necessarily having occurred.

CDS Settlement

Under the current RBI framework, credit-derivative contracts can be:

• cash settled; or

• physically settled.

CDS can also use auction settlement under the prescribed framework.

For CAIIB, the important distinction is:

Cash Settlement

The contractual loss is settled in cash.

Physical Settlement

The protection buyer delivers an eligible obligation and receives the contractual amount according to the CDS terms.

Do not assume every CDS must use physical settlement.

What Is a Total Return Swap?

Under RBI’s current 2026 Directions, a Total Return Swap (TRS) is a credit derivative in which the total return payer transfers the entire economic performance of a reference asset to the total return receiver, while receiving an agreed fixed or floating payment linked to a benchmark.

“Total economic performance” can include effects such as:

• interest/coupon income;

• price appreciation; and

• price depreciation

according to the contract.

The important idea is:

CDS mainly transfers specified credit-event risk.

TRS transfers the broader economic performance of the reference asset.

CDS vs TRS

Case 7: Bank Wants to Retain Legal Ownership but Transfer Bond Economics

A bank owns an eligible corporate bond.

For balance-sheet reasons, it does not immediately sell the bond, but it wants another permitted counterparty to receive its economic performance.

Possible Instrument

A properly structured TRS may be considered, subject to RBI eligibility and other requirements.

Economic Result

The bank may transfer:

• coupon/return;

• positive market performance; and

• negative market performance

according to the TRS terms, while receiving the agreed benchmark-linked payment.

CAIIB Learning

TRS goes beyond simple default protection.

It transfers a much broader part of the asset’s economic behaviour.

Case 8: ALCO Wants to Hedge Rising Interest Rates with CDS

The bank has a large fixed-rate loan and investment portfolio.

ALCO expects interest rates to rise.

Treasury proposes buying CDS.

Analysis

Wrong instrument for the primary risk.

The main exposure is:

Interest-Rate Risk

not:

Credit Event Risk

Treasury should examine appropriate interest-rate tools such as:

• IRS;

• futures; or

• other permitted interest-rate derivatives,

depending on the exposure.

CAIIB Learning

Identify the risk before selecting the derivative.

Case 9: Floating Funding Creates NII Risk

The bank has fixed-rate assets funded by floating-rate liabilities.

Rates are rising.

Possible ALM Response

ALCO may decide to reduce repricing risk.

Treasury can consider a suitable:

Pay-Fixed / Receive-Floating IRS

The swap can offset part of the floating funding exposure.

Residual Risks

The hedge may still contain:

• basis risk;

• counterparty risk;

• tenor mismatch;

• collateral requirements; and

• operational risk.

CAIIB Learning

Derivatives can modify the repricing structure without changing the underlying loan book.

Case 10: USD Assets Funded by INR Liabilities

A bank has a long-term USD asset but primarily INR funding.

Risk

The bank has:

• currency mismatch; and potentially

• interest-rate mismatch.

ALM Response

A suitable currency/cross-currency swap may help align the economic liability with the asset.

CAIIB Learning

A credit derivative would not solve a pure currency mismatch.

Use the derivative corresponding to the risk.

Case 11: Credit Protection Seller Treated as Risk-Free Income

A permitted institution sells CDS protection and receives periodic premium.

Management describes the premium as low-risk income.

Analysis

Incorrect.

The protection seller has accepted credit risk.

If the contractual credit event occurs, it may have to make the required settlement payment.

The protection seller also needs to consider:

• concentration;

• correlation;

• reference-entity quality;

• market value;

• counterparty exposure;

• capital;

• liquidity; and

• stress scenarios.

CAIIB Learning

Protection buyer transfers credit risk.

Protection seller assumes credit risk.

Premium is compensation for accepting that risk.

Case 12: Diversification through Credit-Index Derivative

A bank holds a diversified corporate-debt portfolio.

The main concern is broad deterioration in credit conditions rather than only one named issuer.

The current 2026 RBI framework expanded the Indian credit-derivative architecture to include credit-index products, including CDS on eligible credit indices and exchange-traded futures on eligible credit indices.

ALM Significance

Such products can potentially help manage portfolio-level credit exposure where permitted and appropriately matched.

CAIIB Learning

Single-name risk → Single-name CDS may fit

Broad portfolio/index risk → Credit-index instrument may be more relevant

But index hedging can still leave basis risk because the bank’s portfolio may not exactly match the index.

Case 13: Credit Hedge Reduces Default Risk but Creates Counterparty Risk

A bank buys OTC CDS protection from another institution.

The reference entity later becomes weaker, making the CDS valuable to the bank.

At the same time, the protection seller’s financial strength deteriorates.

Analysis

The bank has transferred some issuer credit risk but acquired exposure to the protection seller.

This is counterparty credit risk.

RBI’s OTC derivative framework requires derivative market-makers to identify risks, establish risk limits, conduct stress testing, and manage counterparty credit exposure, including through appropriate collateral where permitted.

CAIIB Learning

A hedge is only as useful as the protection structure and the ability of the counterparty to perform.

Case 14: ALCO Looks Only at On-Balance-Sheet Positions

ALCO measures:

• loans;

• deposits; and

• investments

but ignores swaps and credit derivatives.

Analysis

This produces an incomplete risk picture.

Derivative positions can materially change:

• repricing exposure;

• currency exposure;

• credit exposure;

• liquidity through collateral/margin calls; and

• counterparty exposure.

RBI’s liquidity-risk framework requires banks to identify liquidity risk arising from major on- and off-balance-sheet positions, including contingent exposures.

CAIIB Learning

ALM must consider economic exposure after derivatives—not only the accounting face of the balance sheet.

Case 15: Derivative Hedge Creates Margin Liquidity Pressure

A derivative hedge is economically effective.

However, adverse mark-to-market movement requires the bank to post additional collateral.

The underlying asset has an offsetting gain, but that gain is not immediately realised.

Analysis

Market risk may have been reduced, but liquidity risk has increased.

Treasury must forecast:

• collateral calls;

• cash requirements;

• available high-quality collateral; and

• stress funding capacity.

CAIIB Learning

Derivative-based ALM should examine both:

Value Risk

and

Cash-Flow/Liquidity Risk

Case 16: Bank Assumes CDS Automatically Gives Regulatory Capital Relief

A bank buys CDS and immediately reduces its regulatory capital requirement without checking the prudential rules.

Analysis

Incorrect.

A credit derivative may reduce economic credit risk, but regulatory recognition depends on the applicable:

• capital rules;

• credit-risk-mitigation conditions;

• documentation;

• maturity;

• reference exposure; and

• other eligibility requirements.

The current Credit Derivatives Directions also require market participants to follow the prudential norms and capital requirements issued by their respective regulators.

CAIIB Learning

Economic hedge ≠ automatic regulatory capital relief

Derivative Risks that ALCO Must Consider

Current Credit-Derivative Controls Important for CAIIB

Under RBI’s Credit Derivatives Directions, 2026:

• the framework applies to both OTC and recognised exchange markets;

• permitted OTC products include CDS and TRS;

• single-name and eligible index-based credit derivatives are recognised;

• retail and non-retail user classifications affect permitted participation;

• market-makers cannot offer CDS or TRS to individuals;

• hedging transactions must be backed by qualifying exposure and appropriately matched in amount and tenor;

• hedging positions must be exited after the underlying exposure ceases, within the prescribed period;

• OTC credit-derivative transactions by market-makers are reportable to CCIL’s Trade Repository; and

• prudential, accounting and capital treatment continues to depend on the applicable regulator.

The major CAIIB lesson is not to treat “credit derivative” as unrestricted insurance against every credit loss.

Its use is governed by:

Product + Participant + Purpose + Reference Exposure + Amount + Tenor + Settlement + Prudential Rules

Practical ALM Decision Framework

When ALCO considers a derivative, use the following sequence.

1. Identify the Existing Exposure

Is the bank facing:

• repricing risk;

• FX risk;

• bond-price risk;

• default/credit-spread risk; or

• portfolio credit risk?

2. Decide the Desired Exposure

Does ALCO want to:

• eliminate;

• reduce;

• cap; or

• transform

the risk?

3. Select the Matching Derivative

Choose according to the risk, not product familiarity.

4. Match the Hedge

Check:

• notional;

• maturity;

• currency;

• benchmark;

• reference entity/index;

• cash-flow dates.

5. Assess New Risks

Review:

• counterparty;

• collateral;

• liquidity;

• basis;

• operational; and

• legal risks.

6. Check Regulatory Treatment

Confirm:

• eligibility;

• permitted purpose;

• current RBI directions;

• capital treatment;

• reporting; and

• internal limits.

7. Monitor the Net ALM Position

ALCO should evaluate the combined underlying plus derivative exposure.

CAIIB Exam Focus

Derivatives are tools within ALM, not substitutes for ALM.

IRS primarily manages interest-rate exposure.

Currency derivatives manage FX exposure.

Credit derivatives transfer credit-related risk.

CDS protection buyer pays premium and obtains contractual credit-event protection.

CDS protection seller receives premium and assumes specified credit risk.

TRS transfers broader economic performance of the reference asset.

Current RBI Credit Derivatives Directions, 2026 became effective on June 25, 2026 and superseded the 2022 framework.

The 2026 framework includes CDS, TRS and credit-index derivatives.

A hedge must match the underlying exposure in amount and tenor under applicable rules.

Loss of underlying exposure can require exit from a credit derivative entered for hedging.

Credit protection does not automatically remove interest-rate, liquidity or counterparty risk.

Buying CDS does not automatically guarantee regulatory capital relief.

ALM must include derivative and other off-balance-sheet exposures.

Margin or collateral calls can turn a market hedge into a liquidity-management issue.

ALCO should assess the net risk after the derivative—not each transaction in isolation.

Common Exam Traps

Trap 1: CDS Protects against Every Fall in Bond Price

Incorrect.

CDS responds to specified credit-event conditions; bond prices can fall for many other reasons.

Trap 2: Protection Seller Has No Credit Risk

Incorrect.

The protection seller assumes the contractual credit-event obligation.

Trap 3: CDS Is an Interest-Rate Hedge

Incorrect.

CDS primarily transfers credit risk.

Trap 4: Credit Derivative Requires Sale of the Underlying Bond

Incorrect.

The credit risk can be transferred without necessarily selling the debt instrument.

Trap 5: CDS and TRS Are the Same

Incorrect.

CDS focuses on specified credit-event protection; TRS transfers broader economic performance.

Trap 6: More Protection than Underlying Exposure Creates a Better Hedge

Incorrect.

It can create over-hedging and a new risk position.

Trap 7: Hedge Tenor Can Be Unrelated to Underlying Maturity

Incorrect for a qualifying hedge under the applicable RBI framework.

Trap 8: A Hedge Can Be Retained Indefinitely after the Underlying Is Sold

Incorrect for credit derivatives undertaken for hedging under the current RBI framework.

Trap 9: Buying Credit Protection Removes All Risk

Incorrect.

Counterparty, basis, liquidity and operational risks can remain.

Trap 10: Derivatives Affect Only Market Risk, Not Liquidity

Incorrect.

Collateral and margin requirements can create substantial liquidity needs.

Trap 11: Regulatory Capital Automatically Falls after CDS Purchase

Incorrect.

Regulatory recognition depends on applicable prudential conditions.

Trap 12: Current Credit-Derivative Regulation Is Still the 2022 Direction

Incorrect.

RBI issued the superseding Credit Derivatives Directions, 2026 on June 25, 2026.

Memory Technique

Remember R-M-H-R for an ALM derivative decision:

• R – Risk identified

• M – Match the derivative

• H – Hedge the intended exposure

• R – Review residual risk

For credit derivatives:

Buyer Buys Protection

Seller Sells Protection and Takes Credit Risk

And remember the central CAIIB principle:

ALM should judge the combined position after the derivative—because a derivative may reduce one risk while creating another.