Can someone explain credit default swaps at a CFA Level I depth — what they are, how they work, and why they matter?

Credit default swaps are the most important credit derivative and are heavily tested across all CFA levels. Here's a clear Level I walkthrough.

What a CDS Is:

A credit default swap is a bilateral contract where the protection buyer pays periodic premiums (the 'CDS spread') to the protection seller in exchange for a contingent payment if a specified credit event occurs on a reference entity.

The Mechanics:

Credit Events (Triggers):

1. Bankruptcy — The reference entity files for bankruptcy protection
2. Failure to pay — Missing a scheduled interest or principal payment beyond a grace period
3. Restructuring — Modification of debt terms (e.g., maturity extension, coupon reduction) that disadvantages creditors

Settlement Methods:

• Physical settlement: Protection buyer delivers the defaulted bond; seller pays par value
• Cash settlement: Seller pays (par value - recovery value). If recovery is 40 cents on the dollar, the seller pays 60% of notional

Example:

Maple Ridge Insurance Company buys 5-year CDS protection on $10M notional of Zenith Telecom bonds from Pinnacle Bank. The CDS spread is 250 bps per year.

• Maple Ridge pays: $10M x 2.50% / 4 = $62,500 per quarter
• If Zenith defaults with 35% recovery: Pinnacle pays $10M x (1 - 0.35) = $6.5M
• If no default: Maple Ridge has paid $62,500 x 20 quarters = $1.25M for 'insurance' it didn't need

Why Buy CDS Without Owning the Bond?

This is called a 'naked' CDS position and serves several purposes:

1. Speculation — If you believe a company's credit will deteriorate, buying CDS is more liquid than shorting bonds
2. Hedging portfolio risk — A credit fund might buy CDS on an entire sector as a macro hedge
3. Basis trading — Exploiting the difference between bond spreads and CDS spreads

CDS Spread as a Market Signal:

The CDS spread reflects the market's real-time assessment of default probability. If Zenith's CDS widens from 250 bps to 500 bps, the market believes default risk has doubled — even before any rating agency downgrades.

Exam Focus: At Level I, know the basic structure (who pays whom), the three credit events, the two settlement methods, and understand that CDS spreads provide market-implied default probability signals.

Explore credit markets further in our CFA Level I fixed income modules.