Credit Default Swap

Economically a CDS has a premium leg and a protection leg. The buyer pays a fixed coupon on the contract notional, typically quarterly on standardised roll dates, and stops paying the moment a credit event is confirmed. The seller owes nothing unless that event occurs, at which point it pays the notional loss, conceptually notional multiplied by one minus the recovery rate.

Fair pricing equates the present value of the two legs. Because market convention fixes the coupon at standard levels rather than at the fair spread, the difference is settled through an upfront payment. As an approximation, the upfront percentage equals the difference between the CDS spread and the fixed coupon, multiplied by the credit spread duration of the contract. A wider market spread than the coupon means the protection buyer pays the seller upfront; a tighter spread means the seller pays the buyer.

Whether a credit event has occurred is not left to the two counterparties. Regional ISDA Determinations Committees rule on the question, on which obligations are deliverable, and on the succession of the reference entity after mergers or spin-offs. That standardisation is what makes the contract fungible enough to clear and to trade in size.

Settlement was historically physical, with the buyer delivering defaulted bonds against par. Because outstanding CDS notional often far exceeded the deliverable debt, the market moved to cash settlement via an auction that establishes a single final price for the reference obligations. Protection buyers receive notional less that auction price. The mechanism removes the squeeze created when many buyers had to source the same scarce bonds, and it fixes recovery transparently for every contract on the name.

Liquidity concentrates in two places. Single-name contracts reference one issuer, most actively investment-grade and high-yield corporates plus sovereigns. Index CDS reference equally weighted baskets, notably the CDX family in North America and iTraxx in Europe and Asia, and are used to take or hedge broad credit beta cheaply. When a constituent defaults, it is removed and the index notional is reduced proportionately.

Comparing a CDS spread with the credit spread on the issuer's bonds gives the basis. A negative basis, where protection is cheap relative to the cash bond spread, invites buying the bond and buying protection; a positive basis invites the reverse. The basis is driven by funding costs, counterparty and documentation differences, deliverability options and short-selling frictions rather than by pure default probability.

Expect to move fluently between spread, hazard rate and expected loss: the annual expected loss on a name is roughly its conditional default probability multiplied by the loss given default, so a spread of a few hundred basis points implies a specific default intensity once recovery is assumed. You should be able to state the payoff on a credit event and compute the upfront payment from spread, coupon and duration.

Equally testable is mark-to-market after entry. If spreads widen, a protection buyer holds a gain approximately equal to the spread change times duration times notional, which can be monetised by unwinding with the counterparty, entering an offsetting contract, or holding to maturity. Finally, recognise the standard trade expressions: long or short credit risk, curve steepeners and flatteners across maturities, basis trades, and capital structure positions pairing CDS against equity.