Credit Default Swaps Contracts
Credit Default Swaps Contracts
A credit default swap (CDS) is a derivative contract that transfers credit risk from a protection buyer to a protection seller. The buyer pays a periodic premium in exchange for compensation if the reference entity experiences a credit event such as default, bankruptcy, or restructuring.
Definition and Key Concepts
Core Structure
Parties:
- Protection buyer: Pays premium; receives payment if credit event occurs
- Protection seller: Receives premium; pays if credit event occurs
Economic purpose: CDS functions as insurance against credit risk. Unlike insurance, CDS can be bought without owning the underlying bond (naked CDS).
Key Terms
| Term | Definition |
|---|---|
| Reference entity | Issuer whose credit risk is being transferred |
| Reference obligation | Specific bond or loan category defining seniority |
| Notional amount | Face value of protection purchased |
| Premium (spread) | Annual cost quoted in basis points |
| Credit event | Trigger for protection payment |
| Recovery rate | Percentage of notional recovered post-default |
Credit Events
Standard ISDA credit events include:
| Event | Definition |
|---|---|
| Bankruptcy | Legal insolvency proceedings |
| Failure to pay | Missed payment beyond grace period |
| Restructuring | Material modification of debt terms |
| Repudiation/moratorium | Sovereign rejects obligations |
| Obligation acceleration | Early payment demand triggered |
| Obligation default | Technical default on debt covenants |
North American contracts: Typically exclude restructuring (no-R) European contracts: Typically include modified restructuring (Mod-R)
How It Works in Practice
Premium Payment Mechanics
CDS premiums are quoted as annual rates but paid quarterly:
Quarterly premium: Premium = Notional × Spread × (Days in Quarter / 360)
Payment dates: March 20, June 20, September 20, December 20 (IMM dates)
Accrued premium: If credit event occurs mid-period, buyer owes accrued premium up to event date.
Market Conventions
| Feature | Standard Term |
|---|---|
| Contract tenor | 5 years (most liquid) |
| Quote convention | Spread in bps (e.g., 100 bps) |
| Day count | Actual/360 |
| Payment frequency | Quarterly |
| Business day | Following, Modified Following |
| Holiday calendar | Target for EUR, NY/London for USD |
Index CDS
For diversified credit exposure, indices aggregate multiple single-name CDS:
| Index | Region | Constituents | Seniority |
|---|---|---|---|
| CDX.NA.IG | North America | 125 investment grade | Senior unsecured |
| CDX.NA.HY | North America | 100 high yield | Senior unsecured |
| iTraxx Europe | Europe | 125 investment grade | Senior unsecured |
| iTraxx Crossover | Europe | 75 high yield/crossover | Senior unsecured |
Index CDS provides broad market credit exposure with single trade execution.
Worked Example
Trade details:
- Reference entity: ABC Corporation
- Notional: $10 million
- Spread: 150 bps per annum
- Tenor: 5 years
- Protection buyer: Hedge Fund Alpha
Quarterly premium payment: Premium = $10,000,000 × 1.50% × (91/360) Premium = $10,000,000 × 0.015 × 0.2528 Premium = $37,917
The protection buyer pays $37,917 each quarter (approximately $151,667 annually).
Credit Event Scenario
Assumptions:
- Credit event occurs after 18 months
- Recovery rate: 40%
Protection buyer receives: Settlement = Notional × (1 - Recovery Rate) Settlement = $10,000,000 × (1 - 0.40) Settlement = $6,000,000
Net economics:
| Cash Flow | Amount |
|---|---|
| Premiums paid (6 quarters) | -$227,500 |
| Settlement received | +$6,000,000 |
| Net gain to protection buyer | +$5,772,500 |
Protection seller loses:
| Cash Flow | Amount |
|---|---|
| Premiums received | +$227,500 |
| Settlement paid | -$6,000,000 |
| Net loss to protection seller | -$5,772,500 |
Settlement Methods
Physical settlement:
- Protection buyer delivers defaulted bonds
- Protection seller pays par (100% of notional)
- Buyer retains any recovery value
Cash settlement:
- ISDA auction determines final price
- Settlement = Notional × (100% - Auction Price)
- No bond delivery required
Auction mechanics: After credit event, ISDA conducts auction to determine recovery rate. Dealers submit bids and offers; final price sets cash settlement amount.
Risks, Limitations, and Tradeoffs
Protection Buyer Risks
| Risk | Description |
|---|---|
| Premium drain | Ongoing cost if no credit event |
| Wrong-way risk | Seller defaults when protection needed most |
| Basis risk | CDS spread may not track bond spread exactly |
| Documentation risk | Credit event may not trigger as expected |
Protection Seller Risks
| Risk | Description |
|---|---|
| Credit loss | Full (1 - recovery) exposure on default |
| Jump-to-default | No warning before credit event |
| Concentration | Large exposure to single name |
| Correlation | Multiple credits default together |
Counterparty Credit Risk
Pre-credit event: If CDS spread widens significantly, protection buyer has mark-to-market gain and counterparty exposure to seller.
Example: Spread widens from 150 bps to 500 bps on $10M 5-year CDS: MTM gain ≈ $10,000,000 × (5.00% - 1.50%) × 4 years (duration) = $1,400,000
Protection buyer now has $1.4 million counterparty exposure.
Basis Risk: CDS vs. Bond Spread
| Factor | Effect on Basis |
|---|---|
| Liquidity | CDS often more liquid; basis can widen |
| Deliverable cheapest | Buyer delivers cheapest bond; affects economics |
| Funding costs | Cash bond requires funding; CDS does not |
| Repo specialness | Hard-to-borrow bonds affect arbitrage |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Successor events | Company restructures; CDS may transfer | Review successor provisions |
| Orphaned CDS | Reference entity no longer exists | Monitor corporate actions |
| Restructuring disputes | Disagreement on whether event qualifies | Specify restructuring terms (Mod-R, Mod-Mod-R) |
| Premium accrual on default | Owed but often forgotten | Include in settlement calculation |
Checklist and Next Steps
Pre-trade checklist:
- Confirm reference entity legal name and ticker
- Verify reference obligation and seniority
- Check notional amount and direction (buy/sell protection)
- Confirm spread in basis points
- Review credit event definitions (restructuring terms)
- Verify physical vs. cash settlement provisions
- Ensure ISDA Master Agreement and confirmations in place
- Check margin requirements and collateral terms
Event monitoring checklist:
- Monitor reference entity credit metrics
- Track spread movements daily
- Review ISDA credit event determinations
- Verify payment amounts on scheduled dates
- Update counterparty exposure calculations
Related articles:
- For total return swaps, see Total Return Swaps for Equity Exposure
- For commodity swaps, see Commodity Swaps for Producers and Consumers