Credit · C7 · 10 min
Credit default swaps
Buy or sell insurance against a company defaulting, work out the upfront payment, and value the trade as its spread moves.
In the news: “The bank’s five-year CDS jumped 80bp”: insuring its debt now costs more, and those who already bought insurance are up.
The essentials
- Credit default swap
- A contract that insures against a company defaulting. The protection buyer pays a yearly fee and is short credit, gaining as the company weakens; the seller covers the loss in a default and is long credit, like owning the bond.
- Credit events and the auction
- A payout needs a : usually bankruptcy or a missed payment, in some contracts a forced restructuring. An then sets one recovery price: at 35, sellers pay 65% of the amount covered.
- Standard fee and upfront
- Standard contracts pay a fixed yearly fee, usually 100 or 500bp, and settle the gap to the market spread at the start. With a of 4.4, 180bp against a 100bp fee costs the buyer about 3.5% upfront.
- Marking to market
- An existing contract’s value changes by about the change in spread times risky duration times the amount covered. €10m bought at 180bp is up about €308,000 if the spread reaches 250bp; the seller is down the same.
- The CDS–bond basis
- The gap between a company’s CDS spread and its bond spread, which should be close because both pay for the same default risk. When the bond pays more, buying it and buying protection earns the gap with default covered.
CDS upfront
Upfront ≈ (spread − fee) × RD × amount covered
- spread
- what the market says protection is worth, a year
- fee
- the contract’s standard yearly fee: 100bp or 500bp
- RD
- risky duration: about 4 for a 5-year contract
How it works
1. Insurance on a loan
A , or CDS, is insurance against a company defaulting. The buyer pays a yearly fee; if the company defaults, the seller covers the loss, much like insuring a house. An investor who owns £10m of a company’s bonds and worries it might default can buy protection on £10m.
2. Buyer and seller
The protection buyer pays the fee; the protection seller pays out if the company defaults. You don’t need to own the bonds: buying protection gains when the company’s credit gets worse, which is being short credit. Selling protection is long credit, like owning the bond.
3. What triggers a payout
A payout needs a : usually bankruptcy or a missed payment, and in some contracts a forced restructuring of the debt. A committee of banks and investors decides whether one has happened.
4. The auction
After a default, an of the company’s bonds sets one recovery price for every contract. If the bonds fetch 35, protection sellers pay buyers 65% of the amount covered, in cash.
5. A standard fee, settled upfront
Since 2009, North American contracts pay a fixed yearly fee: 100bp (1% a year) for safer companies, 500bp for riskier ones. The market still quotes its own price as a spread. If protection is worth 180bp but the contract pays 100bp, the buyer makes up the difference with a payment at the start: the .
6. Sizing the upfront
Upfront ≈ (spread − fee) × × amount covered. Risky duration is about 4 for a 5-year contract: roughly the years of fee you expect to pay before maturity or default. At 180bp against a 100bp fee: 0.8% × 4.4 × €10m ≈ €352,000.
7. Marking to market
Once you have a contract, its value moves with the spread: change ≈ change in spread × risky duration × amount. Buy €10m at 180bp; if the spread goes to 250bp, you are up about 0.7% × 4.4 × €10m ≈ €308,000. The seller is down the same.
8. The CDS–bond basis
A company’s CDS spread and its bond’s spread should be close, because both pay for the same default risk. The gap is the . If the bond pays more than protection costs, buying both earns the difference while you are covered against default.
Try it
A protection seller needs a fee that covers the expected loss. Move the chance of default and the recovery to see it, or set a spread and read the default chance it implies.
spread ≈ PD × (1 − recovery)
- Spread that pays for it
- 120bp
- Expected loss a year on £10m
- £120,000
- Chance of default within 5 years
- 9.6%
| Annual default probability | Spread |
|---|---|
| 1% | 60bp |
| 2% | 120bp |
| 5% | 300bp |
| 10% | 600bp |
Worked example
You buy €10m of 5-year protection on a European company whose CDS trades at 180bp. The contract fee is 100bp and the risky duration 4.4. Later the spread widens to 250bp.
- Upfront: (1.80% − 1.00%) × 4.4 × €10m = €352,000, paid by you.
- Then the fee: 100bp a year, about €25,000 a quarter.
- Spread to 250bp: (2.50% − 1.80%) × 4.4 × €10m ≈ €308,000 gain.
- If the company then defaults and the auction price is 35, you are paid €10m × 65% = €6.5m.
Pay €352,000 upfront plus 100bp a year; a move to 250bp is worth about +€308,000; a default at 35 pays €6.5m.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
If you buy CDS protection, are you long or short credit?
Why might CDS trade wider than the bond’s spread?
What counts as a credit event?
Remember
Upfront ≈ (spread − fee) × risky duration
Buying protection is short credit: you pay the fee, settle the difference upfront, and gain as the spread widens.
Sources
- Bank for International Settlements — The “Big Bang” in the CDS market
- ISDA — ISDA Publishes ISDA 2014 Credit Derivatives Definitions
Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.