Credit Default Swaps · Swaps Trading Guide

A CDS spread compensates for more than a single probability of default. Standard coupons and upfront payments make quote interpretation especially important.

The spread is a market price

A wider CDS spread generally indicates more expensive protection, but it is not a direct reading of default probability. Expected recovery, the timing of default, discount rates, liquidity and risk compensation influence the price. Comparing two issuers also requires compatible seniority, currency, documentation and maturity.

Recognize a standard coupon contract

A contract can retain a standardized running coupon while an upfront payment balances its market value. If fair protection is more expensive than the contractual coupon, the protection buyer will generally compensate the seller upfront, with other terms equal. Accrued amounts and market conventions affect the quoted cash settlement.

Use a rough probability relationship carefully

A highly simplified approximation relates annual spread to default intensity multiplied by loss given default. At a 1.2% spread and 60% loss assumption, dividing 1.2% by 60% gives 2% per year. This is only an illustrative intensity approximation. It is neither an observed default frequency nor a complete multiyear valuation.

Mark the existing position correctly

Protection bought before spreads widen can gain market value, but that gain is not the full contingent payout. Realizing it requires an executable offset or termination and incurs costs. Report running premium, upfront settlement and valuation changes separately so that an apparently cheap coupon is not mistaken for the entire cost.

Try it yourself

A quote requires the buyer to pay 2% upfront on $5,000,000 notional, plus a running coupon. What is the upfront amount?

Show the worked answer

The upfront amount is $100,000 before accrued premium or other settlement adjustments. It does not replace the future running coupon obligations.

Further reading

Educational material, not a recommendation to transact. Numerical examples are hypothetical and simplify contract terms. Access, documentation, collateral and regulatory requirements depend on the product, jurisdiction and counterparties.

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