Interest rate currency and credit derivatives - Credit defau...

Learning Outcomes

This article covers credit default swaps (CDS) and index products for CFA Level 2 candidates, including:

• Explaining the structure, cash-flow mechanics, and contractual features of single-name CDS, index CDS, and the role of the reference obligation.
• Detailing standard CDS contract parameters such as notional principal, maturity, premium leg, protection leg, credit events, settlement method, and cheapest-to-deliver (CTD) bonds.
• Describing how bankruptcy, failure to pay, and restructuring events are determined, and how ISDA settlement protocols translate these events into cash or physical payouts.
• Applying core CDS pricing relationships, including the link between spreads, hazard rates, and recovery assumptions, to approximate fair value spreads and simple protection payments.
• Interpreting changes in CDS spreads as signals of evolving credit risk and recognizing the mark-to-market effects for protection buyers and sellers.
• Evaluating how CDS instruments are used to hedge bond portfolios, express credit views, trade the credit curve, and implement arbitrage or basis trading strategies.
• Comparing the risk-transfer, diversification, and practical implementation features of single-name CDS versus CDS index products in portfolio and risk-management contexts.

CFA Level 2 Syllabus

For the CFA Level 2 exam, you are expected to understand the structure, features, and applications of credit default swaps and index derivatives within the area of interest rate, currency, and credit derivatives, with a focus on the following syllabus points:

• Explain credit default swaps (CDS), single-name and index CDS, and key contract parameters.
• Describe credit events and the mechanics of cash and physical settlement.
• Explain the main drivers of CDS pricing and calculate simple payouts.
• Discuss uses of CDS in credit risk management and implementing views on credit risk.
• Identify uses of CDS for arbitrage and basis trading opportunities.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the cheapest-to-deliver (CTD) bond in the context of a single-name CDS?
2. Which credit events typically trigger a payout under a standard CDS contract?
3. If a CDS spread rises for an issuer, what does this imply about the market’s perception of credit risk?
4. In a CDS index contract, how is the notional exposure adjusted after a default of one constituent?

Introduction

Credit default swaps (CDS) are a primary instrument for managing and expressing views on credit risk in the modern financial system. They offer a means for investors to obtain protection against the default of a reference entity or gain exposure to credit risk without direct bond ownership. Index CDS provide exposure to a basket of credits, allowing for efficient risk transfer and speculation on credit markets. This article outlines the main features, pricing, and practical uses of CDS and CDS indexes for CFA Level 2 candidates.

Key Term: credit default swap (CDS)
A derivative contract in which the protection buyer pays periodic premiums to the protection seller, who compensates the buyer if a credit event (such as default) occurs in a specified reference entity.

Structure and Types of CDS Instruments

A single-name CDS is written on a specific reference entity, usually with the reference obligation being a senior unsecured debt. In a standard contract, the protection buyer pays a periodic fee (the CDS spread) to the seller. In exchange, if a defined credit event occurs with respect to the reference entity, the protection seller compensates the buyer, typically for the shortfall in value of a defaulted debt instrument.

Key Term: credit event
A contractually defined occurrence (such as bankruptcy, failure to pay, or restructuring) that triggers a payout under a CDS.

Key Term: reference obligation
The specific bond or loan of the reference entity on which the CDS contract is written and whose credit risk is being transferred.

Key Term: cheapest-to-deliver (CTD) bond
After a credit event, the deliverable security of eligible seniority that can be delivered by the CDS protection buyer at the lowest market value, used to determine the CDS payout.

CDS index products (e.g., CDX, iTraxx) cover portfolios of equally weighted reference entities. Protection payouts for individual credit events affect only the notional associated with the defaulted name, and the index contract continues for the remaining notional.

CDS Contract Parameters and Market Features

CDS contracts specify the notional principal, premium (spread), maturity, reference entity, reference obligation, credit events, and the method of settlement (cash or physical). Most liquid CDS now trade with a standardized coupon, with any difference in spread reflected in an upfront payment at contract initiation.

Key Term: CDS spread
The periodic payment (expressed in basis points per annum) made by the protection buyer to the seller, reflecting the perceived credit risk of the reference entity.

Key Term: notional principal
The contractual amount on which the protection payment is calculated, but which does not change hands unless a credit event occurs.

CDS market conventions, including the International Swaps and Derivatives Association (ISDA) standard contracts, ensure legal and payment uniformity.

Credit Events and Settlement Protocols

A CDS contract triggers a protection payout if a contractually defined credit event occurs. Common credit events are:

• Bankruptcy of the reference entity
• Failure to pay principal or interest
• Debt restructuring (varies by region and contract type)

The determination of a credit event is made by the ISDA Determinations Committee, typically requiring a supermajority vote.

After a credit event, settlement occurs by one of two main mechanisms:

• Physical delivery: The protection buyer delivers an eligible defaulted bond (the CTD) to the seller for the notional amount.
• Cash settlement: The seller pays the buyer the notional amount less the post-default market value of the CTD; the payout reflects the actual loss experienced.

Key Term: cash settlement
A CDS settlement protocol in which, after a credit event, the protection seller pays the buyer the difference between the notional value and recovery value of the CTD bond.

Key Term: physical settlement
A settlement method where the protection buyer delivers an eligible defaulted security to the seller in exchange for the notional amount.

Worked Example 1.1

A fund manager holds $10 million notional in a 5-year CDS on Company Z, referencing senior unsecured debt. After two years, Company Z files for bankruptcy, and its cheapest-to-deliver senior bond trades at 40% of par. What is the cash settlement received by the protection buyer?

Answer:
The cash settlement equals notional × (1 – recovery rate)
= $10 million × (1 – 0.40) = $6 million.

Worked Example 1.2

A CDS index has a total notional of $100 million and contains 50 names, each with $2 million notional exposure. If one constituent defaults and its recovery value is 25%, what happens?

Answer:
The protection buyer receives: $2 million × (1 – 0.25) = $1.5 million.
After settlement, the index notional is reduced to $98 million as the defaulted name is removed.

CDS Pricing Principles

The fair value CDS spread is determined by three main factors:

1. Probability of default (annualized hazard rate) of the reference entity
2. Loss given default (1 – expected recovery rate)
3. Market conventions (e.g., contract maturity, standard coupon, and upfront payments)

At initiation, the present value of expected premium payments equals the present value of expected protection payments (payouts on credit event).

The standard approximation links the CDS spread (s), hazard rate (h), and recovery rate (R):

$s \approx h \times (1 – R)$

Key Term: hazard rate
The probability per period (typically annualized) that the reference entity will default within that period, given survival to its start.

The wider the CDS spread, the higher the market-implied probability of default or expected loss. After contract initiation, changes in spreads can lead to mark-to-market profit or loss for participants.

Worked Example 1.3

A 5-year CDS on a BB-rated corporate references $5 million notional, 40% recovery rate. If the annualized hazard rate is 3%, what is the approximate CDS spread?

Answer:
CDS spread ≈ hazard rate × (1 – recovery rate) = 0.03 × 0.60 = 0.018, or 180 basis points.

Exam Warning

The recovery rate used in CDS pricing is an estimate—actual post-default market value may differ. Also, the standardized CDS coupon means that most trades involve an upfront payment to balance the difference between the coupon rate and market spread.

Uses of CDS: Credit Exposure Management and Trading

CDS instruments are used for risk management, speculation, and arbitrage.

• Hedging credit risk: Bondholders can buy protection to insure against issuer default, transferring credit risk to the seller.
• Credit risk-taking: Investors who expect credit conditions of a reference entity to worsen may purchase protection (go long CDS), while those expecting improvement may sell protection (go short CDS) to earn the spread.
• Trading the credit curve: Curve trades involve taking opposing positions in CDS of different maturities to express views on how credit risk is changing over time.
• CDS indexes: Enable rapid diversification and sectoral credit risk management or the execution of macro credit views.

Basis trading seeks to profit from pricing discrepancies between a bond's spread and CDS, known as the CDS-bond basis.

Key Term: CDS-bond basis
The difference between the CDS spread of a reference entity and the cash bond’s credit spread. Opportunities arise when the basis deviates from zero.

Summary

Credit default swaps and index products are central tools for credit risk transfer and management. They provide clear pricing signals, allow active adjustment of credit exposures, and are widely integrated into risk management, hedging, and speculative strategies. Understanding their contractual features, settlement methods, and the core pricing relations is essential for the CFA exam.

Key Point Checklist

This article has covered the following key knowledge points:

• Define single-name and index CDS structures and key parameters.
• List common credit events that trigger CDS payouts.
• Distinguish between cash and physical settlement methods.
• Calculate CDS fair value using hazard rates and recovery assumptions.
• Explain how CDS instruments are applied in hedging, trading, and arbitrage.
• Recognize the mechanics and uses of CDS index contracts.

Key Terms and Concepts

• credit default swap (CDS)
• credit event
• reference obligation
• cheapest-to-deliver (CTD) bond
• CDS spread
• notional principal
• cash settlement
• physical settlement
• hazard rate
• CDS-bond basis