
Before digging into the valuation of a CDS let’s take a closer look at exactly what a CDS is and how it
works.

A Credit Default Swap is a contract where the Seller will compensate the Buyer following the default of a specified third party (the Reference Entity) on its debt1. It is similar to credit insurance, though there are important differences, which are beyond the scope of this post.

The CDS contains two “legs” generally2 referred to as the Protection Leg and the Premium Leg.

## Protection Leg

The Protection leg (also called the Contingent leg) applies after an event of default (a “Credit Event”) by the Reference Entity. If the contract expires without a Credit Event then the leg will have zero cash-flows.

Following a Credit Event3 the Seller pays to the Buyer the Notional less some Recovery Amount. This Recovery Amount is the prevailing market value4 of an amount of the Reference Entity’s debt with the same Notional. Of course, with a defaulted issuer these bonds are expected be worth significantly below par.

## Protection Leg

Under the Premium Leg the Buyer pays the Seller regular premium payments (i.e. coupons / interest). Following a Credit Event these payments stop, however it is normal to make a payment of the premium accrued up to the event of default.

## Summary

We then have four (sets of) cashflows to consider in our valuation:

1. The Notional Amount paid by the Seller following a Credit Event. 
2. The Recovery Amount deducted from 1.
3. The Premiums paid by the Buyer up until any Credit Event.
4. The Accrued Premium paid by the Buyer following a Credit Event.

Generally bonds but also Loans and occasionally other forms of debt too.

The ISDA Credit Derivative Definitions (and therefore trade confirmations) refer to these legs as the Floating and Fixed legs respectively – no doubt an hangover from the days when CDS were new and shoe-horned into interest-rate swap documentation. One could ponder whether the continued use of this style “helps” with the classification of CDS as swaps (and therefore derivatives, not insurance) for the purposes of accounting, tax, regulatory or legal considerations.

It will normally take a period of a few weeks up to a few months following a suspected credit event for any payment to actually be made. The buyer must send notice to the seller (and ISDA) of the suspected event, an ISDA committee is convened and must confirm that an event has actually occurred, then and auction process is convened to set the official recovery rate. This means the time of default and time of payment are not strictly at the same, however for most valuation models they are considered the same and references to “time of default” can be considered references to “time of payment following a default”.

The standard price of the Reference Entity’s bonds to be used in this calculation is determined by ISDA via an auction process following each credit event, there are provisions for parties to agree on other methods. It is also possible to have Physical Settlement whereby the Seller pays the full Notional amount to the Buyer who in turn physically delivers the defaulted bonds to the Seller.

ISDA CDS – How a Credit Default Swap works.

follow or visit us on

Featured Articles