CHAPTER 11

Credit Default Swaps

© 2020 CFA Institute. All rights reserved.

CONTENTS
1 Introduction
2 Basic Definitions and Concepts
3 Basics of Valuation and Pricing
4 Applications of Credit Default Swaps (CDS)
5 Summary

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© 2020 CFA Institute. All rights reserved.
 1. INTRODUCTION
• A credit derivative is a derivative instrument in which the
underlying is a measure of a borrower’s credit quality.
• Credit default swaps (CDS) are a primary type of credit
derivative under which one party makes payments to the
other and is promised compensation if a third-party
defaults.
• Given that the underlying instrument of a CDS is the credit
quality of a borrower, a CDS provides protection against
changes in the market’s perception of a borrower’s credit
quality even if an actual event of default never occurs.

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 2. BASIC DEFINITIONS AND CONCEPTS
• CDS are contracts between a credit protection buyer who
makes periodic cash payments to a credit protection seller
who promises compensation for losses from a pre-defined credit
event of a third party.
• CDS contracts do not eliminate credit risk, but rather
substitute the CDS seller’s credit risk for that of the underlying
third party. That said, most CDS sellers are relatively high-
quality borrowers.
Periodic Premium
Payments
Protection Protection
Buyer Seller
Payment if Borrower
Defaults

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 TYPES OF CREDIT DEFAULT SWAPS

Three main types of CDS contracts include single-name,

index and tranche CDS :

Single-name CDS is a contract on one specific

borrower (the reference entity) whose debt instrument
designated under the CDS is the reference obligation.

Index CDS involves a group of borrowers, allowing

participants to take positions on the credit risk of a
combination of companies.

Tranche CDS also covers a combination of borrowers,

but only up to pre-specified levels of losses

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 FEATURES OF CDS MARKETS AND INSTRUMENTS
• CDS contracts generally conform to International Swaps and
Derivatives (ISDA) industry standard documentation and
specifications.
• Each CDS contract specifies a notional amount, or the amount of
protection being purchased as well as an expiration date
• The CDS protection buyer pays a periodic premium to the seller,
referred to as the CDS spread, which is a return over Libor
required to compensate the seller for credit risk.
• Following establishment of a standard annual coupon on CDS
contracts, buyers and sellers exchange an upfront payment
(upfront premium) to account for the present value difference
between the CDS spread and the standard coupon rate.
- If CDS spread > standard coupon, buyer pays seller the premium
- If CDS spread < standard coupon, seller pays buyer the premium
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 FEATURES OF CDS MARKETS AND INSTRUMENTS
• For a single-name CDS:
- reference entity – the issuer of the debt covered by the CDS
- reference obligation – the specific debt instrument covered by the
CDS (usually a senior unsecured debt instrument)

• The CDS protection buyer may hold the securities for which they are
purchasing protection. The CDS is used as a hedge of their position.

• The CDS protection buyer may not actually hold any of the securities for
which they are purchasing protection. The CDS is held for speculative
purposes.

• The notional amount of the protection in the contract can exceed the
amount of debt outstanding of the reference entity. The cash settlement
method makes this possible.
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FEATURES OF CDS MARKETS AND INSTRUMENTS
• Credit protection buyers are considered as having a short position as
they make a series of payments, deliver securities when a credit event
occurs and benefit when things go badly.

• Credit protection sellers are considered as having a long position as

they receive the payments, receive the securities when a credit even
occurs and suffer when things to badly.

• Credit quality is based on the underlying debt obligation (the reference

obligation).

• If credit quality improves, the credit protection seller benefits.

• if credit quality deteriorates, the credit protection buyer benefits.

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 CREDIT EVENTS
• A credit event defines the circumstances which trigger a payment from
the credit protection seller to the credit protection buyer.
• The three general types of credit events are bankruptcy, failure to
pay, and restructuring.

Bankruptcy Failure to Pay Restructuring

Established legal Borrower does not Involuntary event

procedure which make a principal or forced by creditors
forces creditors to interest payment on such as reduction or
defer their claims an outstanding deferral of principal
which is universally obligation after a or interest or change
regarded as a credit grace period with no in seniority or priority
event under CDS formal bankruptcy of payments.
contracts filing

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 CREDIT AND SUCCESSION EVENTS
• The ISDA Determinations Committee (DC) is the official
body which declares a credit event based upon a
supermajority vote of its members
• The DC also determines whether a change in corporate
structure of a CDS reference entity will result in a modification of
existing CDS contracts under what is referred to as a
succession event
• Succession event triggers include mergers, divestitures,
spinoffs, or any similar action in which ultimate responsibility for
the reference obligation debt changes or becomes unclear.
• If the DC declares a credit event has occurred, CDS parties
have the rightPayout ratio30
to settle = 1days
– Recovery
after rate
the (%)
declaration of the
credit eventPayout amount = Payout ratio × Notional
on a physical or cash basis. 1 – Recovery
Payout amount = Payout ratio × Notional

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 SETTLEMENT PROTOCOLS
• Once the DC has declared that a credit event has occurred, the
credit buyer and seller will usually settle 30 days after the event.
• There are two types of settlement: physical settlement and cash
settlement. Cash settlement is the most common.
• In physical settlement, the buyer delivers the debt instrument (the
reference obligation) to the seller and the seller pays the buyer the
notional amount of the contract.
- Physical settlement is useful when the buyer actually owns the
reference obligation. That is, the buyer has used the CDS to hedge
an actual position in that debt instrument.
- Buyer may deliver the cheapest-to-deliver bonds of the same or
higher seniority and same issuer as the reference obligation to
satisfy the contract. In this case buyer does not need to already
own the reference obligation.

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 SETTLEMENT PROTOCOLS
• In the more common cash settlement method under a credit
event, the credit protection seller pays cash to the credit
protection buyer. Used when CDS are used to speculate.
• The payment should reflect the credit protection buyer’s loss in
a default, with the percentage of loss recovered in a default
referred to as the recovery rate.
• The CDS settlement amount is determined by an auction for
the cheapest-to-deliver defaulted debt of the same or higher
seniority and same issuer as the reference obligation. This
identifies market expectations for the recovery rate and the
complementary payout ratio.
• The cash payout is determined as the payout ratio multiplied
by the notional.
Payout ratio = 1 – Recovery rate (%)
Payout amount = Payout ratio × Notional
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SETTLEMENT PROTOCOLS

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SETTLEMENT PROTOCOLS

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 CDS INDEX PRODUCTS (SKIP THIS)
Definition
• CDS index products are tradable instruments based
upon Markit indexes. These CDS contracts generate a
payoff based on any default that occurs on any entity
contained within the index.
Scope
• Indexes are classified by region (North American CDX
or European or Asian iTraxx) and further divided by
credit quality (investment grade versus high yield).

Applications
• Index products are often used to take positions on the
credit risk of the sectors covered by respective indexes
as well as to protect bond portfolios that have a similar
composition to the index components.

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 CDS MARKET CHARACTERISTICS
• The CDS market was established in the 1990s as a
means of separating credit risk from interest rate risk.
CDS trades in an over-the-counter market among
banks and other financial institutions.
• CDS is economically similar to insurance but legally distinct
and is more characteristic of an option than a swap as the
buyer makes periodic payments and expects
compensation under a credit event from the seller.
• Recent regulations mandate central clearing for most CDS
contracts through clearinghouses that impose margin
requirements, mark positions to market and collect and
distribute payments.

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 CDS MARKET CHARACTERISTICS

• Size of CDS market (per BIS report):

- December 2007 – gross notional value of CDS was $57.9
trillion
- June 2012 – gross notional value of CDS was $26.9
trillion
- Single-name CDS account for about 60% of the credit
derivatives market
• CDS trades are traded OTC and are cleared through the
Depository Trust and Clearinghouse Corporation.

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 3. BASICS OF VALUATION AND PRICING (SKIP THIS)
• CDS contract values depend on the likelihood of non-payment of
promised interest and/or principal on a loan or bond.
• The relevant probability of default is conditional over time as each
periodic payment is subject to non-payment.
The hazard rate is the probability that an event will occur given
that it has not already occurred in the past

• The loss in a non-payment scenario (i.e., the foregone receipt of

payment if a default occurs) is referred to as the loss given default.
Expected loss is the promised interest and principal payments
minus expected recovery weighted by the default probability

Expected loss = Loss given default × Probability of default

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 LOAN DEFAULT EXAMPLE (SKIP THIS)
For example, assume a 5%, $1,000 loan with Year 1 and Year 2
hazard rates of 2% and 4%, respectively, and a 40% recovery rate:

Year 0 Year 1 Year 2

$50 at Year 1
96% $1,050 at Year 2
Prob = 94.08%
98% $50
$50 at Year 1
$420 at Year 2
$1,000 2y 4% Prob = 3.92%
loan @ 5%

$20 $20 at Year 1

2% $420 at Year 2
(=$50 x 40%) Prob = 2%

$1,050 – $420 = $630 loss in Year 2 with prob 3.92%

Expected loss = (0.02) × ($660) + (0.0392) × ($630) = $37.90
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LOAN DEFAULT EXAMPLE

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 CDS PROTECTION VERSUS PREMIUM LEGS (SKIP)
CDS contracts consist of two sides or legs – the protection leg
paid by the credit protection seller under a credit event, and the
premium leg paid by the credit protection buyer to the seller

Protection leg: Premium leg:

Discounted Discounted series of
expected payoff promised premium
under a credit Drivers of CDS
contract pricing payments adjusted
event adjusted for by the hazard rate
expected recovery and valuation
for a credit event for
by the probability each interest or
of survival principal payment

Upfront payment:
= PV (Protection Leg) – PV (Premium Leg)

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 THE CDS CREDIT CURVE (SKIP THIS)
• The CDS credit curve is comprised of the credit spread over a
benchmark risk-free rate (commonly LIBOR) for a company’s debt
on a range of maturities with similar reference obligations.
• A credit spread compensates bondholders for assuming credit risk,
which may be expressed roughly as the probability of default
multiplied by the percentage loss given default.
• CDS credit curves are determined by CDS rates and affected by
hazard rates among other factors.

Upward-sloping CDS
credit curves imply a
greater likelihood of Downward-sloping CDS
default in later years curves are less common and
often result from severe
near-term financial stress

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 CDS PRICING CONVENTIONS (SKIP)
• CDS market convention dictates standardized coupons of 1% for
investment-grade debt or 5% for high-yield debt.
• As reference credit spreads typically deviate from standard
coupons, an upfront premium (equal to the present value of the
credit spread minus that of the fixed coupon) is paid from one
party to another.io
• CDS pricing approximations used by industry practitioners include:
Payout amount = Payout ratio × Notional
PV (Credit Spread) = Upfront premium + PV (Fixed Coupon)
Upfront premium ≈ (Credit spread – Fixed coupon) × Duration
Credit spread ≈ (Upfront premium/Duration) + Fixed coupon
Upfront premium % = 100 – CDS Price in currency per 100 par

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 CDS VALUATION CHANGES OVER TIME (SKIP)
A CDS contract’s value will change based on changes to credit
quality of the reference entity including the probability of default
and loss given default as well as shortening duration over time.

For example, for an existing CDS contract where credit quality

has improved, the seller realizes a gain and the buyer a loss

Changes in CDS contract value are represented by the difference

between the original upfront premium and that of a newly created
CDS contract under current market conditions

Approximate CDS value change for a spread or price change:

Protection buyer’s profit = Δ spread (bps) × Duration × Notional
% Δ CDS price = Δ spread (bps) × Duration

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 MONETIZING CDS GAINS AND LOSSES (SKIP)
• CDS price changes give rise to gains or losses which may
be realized (monetized) upon unwinding the position
• The protection seller benefits from credit improvement via
an effective long position, whereas the protection buyer
(who is “short”) gains from a deterioration in credit quality.
• Three possibilities exist to monetize a CDS gain/loss:
Exercise the CDS in response to a credit event

Unwind the position by entering into a new offsetting CDS

Hold the position until expiration

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 4. APPLICATIONS OF CDS (SKIP)
• CDS is most frequently used to manage credit exposure, and have
applications are similar to other derivatives as they:
- Seek to exploit expected changes in the underlying, or
- Take advantage of valuation differences between CDS and the
underlying
• A lender may for example be a credit protection buyer in order to reduce
its credit exposure to a borrower.
• A credit protection seller which gains from credit deterioration may be a
CDS dealer seeking to profit from making markets in CDS.
• Dealers can manage exposure by either diversifying credit risks or by
shorting the debt or equity of the reference entity with a third party.
• A party with no exposure to the reference entity may take what is
referred to as a naked credit default swap position by buying or selling a
CDS contract

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 CDS TRADING STRATEGIES (SKIP)
• CDS trading strategies beyond buying or selling seek to exploit
relative pricing differences across reference entities or time
A long-short strategy involves a long credit position (or CDS
sale) for one reference entity or index and a short position
(purchase of CDS) in another
• This transaction captures the view the credit position of one
entity or index will improve relative to that of another.
A curve trade involves buying a single-name CDS or CDS
index of one maturity and selling a CDS on the same reference
entity with a different maturity.
• Curve trades on single names or an index seek to capitalize on
changes in the shape of the respective CDS credit curve.

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 VALUATION DIFFERENCES AND BASIS TRADING (SKIP)
• Differences in a bond’s credit and CDS spread known as basis can
arise from varying opinions, model difference, relative market liquidity
and repo supply and demand
• If the spread is higher in the bond (CDS) market than the CDS (bond)
market, basis is said to be negative (positive).
• A trader seeking to benefit from this negative basis would buy the CDS
(purchasing protection at a relatively low rate) and buy the bond,
realizing a gain if the basis declines.
• Arbitrage opportunities may also arise for CDS indexes if the index cost
is not equivalent to the aggregate cost of index components.
• For example, a collateralized debt obligation (CDO) comprised of a
claim against a portfolio of debt securities may be replicated in the CDS
market by combining a portfolio of default-free securities with the sale
of credit protection in a synthetic CDO structure.

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 5. SUMMARY
Credit default swaps (CDS), single-name and index CDS and
the parameters that define a given CDS product

• CDS are contracts between a credit protection buyer who

makes periodic cash payments to a credit protection seller
who promises compensation for losses from a pre-defined
credit event of a third party.
• Single-name CDS is a contract on one specific borrower (the
reference entity) whose debt instrument designated under
the CDS is the reference obligation.
• Index CDS involves a group of borrowers, allowing
participants to take positions on the credit risk of a
combination of companies.
• Each CDS contract specifies a reference entity or entities, a
notional amount, or the amount of protection being
purchased as well as an expiration date.
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© 2020 CFA Institute. All rights reserved.
 SUMMARY
CDS credit events and settlement protocols

• A credit event defines the circumstances triggering payment

from the protection seller to the protection buyer and
generally includes bankruptcy, failure to pay, and/or
restructuring (outside of the U.S.).
• The ISDA Determinations Committee (DC) is the official
body which declares a credit event based upon a vote of its
members.
• CDS settlement should reflect the protection buyer’s loss in
a default, and is determined by an auction for the cheapest-
to-deliver defaulted debt to determine the recovery rate and
payout ratio.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Underlying principles and factors driving CDS market pricing

• CDS contract values depend on both the probability of

default of promised interest and/or principal on a loan or
bond as well as the loss given default.
• CDS contracts consist of two sides or legs—the protection
leg paid by the protection seller under a credit event, and the
premium leg paid by the protection buyer to the seller.
• The protection leg is the expected payoff under a credit
event adjusted for recovery by the probability of survival.
• The premium leg is a series of promised premium payments
adjusted by the hazard rate for a credit event for each
interest or principal payment.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Managing credit exposures and expressing views on the
credit curve using CDS
• CDS is most often used to manage credit exposure, for
example where a lender purchases credit protection to
reduce its credit exposure to a borrower.
• Traders seeking to benefit from differences in a bond’s credit
and CDS spread known as basis may buy or sell the CDS,
purchasing (selling) protection at a relatively attractive rate,
and buy or sell the underlying bond to realize a gain if the
basis narrows.
• CDS credit curve trades are used to take a view on the
shape of a single-name CDS or CDS index by purchasing
protection on one maturity and selling a CDS on the same
reference entity with a different maturity.

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© 2020 CFA Institute. All rights reserved.