Credit Default Swaps · Swaps Trading Guide

A credit default swap transfers a defined form of credit risk. The protection buyer pays for a contingent payment, rather than purchasing the issuer’s bond.

Identify the reference exposure

A credit default swap, or CDS, references an entity or specified credit exposure. The protection buyer pays a premium and the protection seller accepts a contingent obligation under the contract. The seller is not the bond issuer. The contract’s reference entity, obligation category, seniority and applicable credit events determine what protection actually covers.

Calculate the premium

For an illustrative $2,000,000 notional and annual premium of 150 basis points, a full year’s simple premium is $30,000. A quarter with an accrual fraction of 0.25 would be $7,500. Real contracts specify payment dates, accrual rules and treatment after a credit event. Some use a standard coupon plus an upfront amount rather than a coupon equal to the quoted spread.

Protection is conditional

A falling share price or a credit rating downgrade is not automatically a contractual credit event. The definitions and determination process matter. If an eligible event occurs, settlement follows agreed procedures. Buying protection also leaves exposure to the protection seller and to operational or legal failures.

Separate a hedge from a credit view

A bond investor may buy CDS to reduce certain default losses. A participant without the bond may also take credit exposure through a CDS where permitted. The latter does not become a risk free transaction because the initial cash commitment is small. Premiums, collateral and changes in market value can produce significant cash demands.

Try it yourself

A $4,000,000 position pays an annual premium of 125 basis points. What is its simple quarterly premium at a 0.25 accrual fraction?

Show the worked answer

The premium is $12,500. Calculate $4,000,000 times 0.0125 times 0.25. An upfront payment, if required, is separate.

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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