How does a credit default swap actually work from inception to credit event?

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AcadiFi · Accepted Answer

A CDS is a bilateral contract where the protection buyer pays a periodic premium (the CDS spread) to the protection seller in exchange for compensation if a reference entity experiences a credit event. Let me walk through the lifecycle using a hypothetical: Kestrel Capital buys 5-year CDS protection on Veridian Industries with $10M notional at 250 bps. Kestrel pays 250 bps × $10M = $250K annually, but since 2009 conventions standardized coupons at 100 or 500 bps, the actual running premium is 100 bps ($100K) with an upfront payment settling the difference. ```mermaid flowchart LR B[Protection
Buyer] -->|Premium
100bps| S[Protection
Seller] S -->|Contingent
Payment| B RE[Reference
Entity] -.->|Credit
Event| S ``` Credit events include bankruptcy, failure to pay, and restructuring (in some jurisdictions). When triggered, ISDA convenes a Determinations Committee to confirm the event. Settlement follows via auction: dealers submit bids for the defaulted bonds, establishing a final recovery price. If recovery is 35%, Kestrel receives $10M × (1 − 0.35) = $6.5M. Premium accrual ceases at the event date. Mark-to-market before a credit event reflects spread changes: if Veridian's spread widens to 500 bps, Kestrel's long protection position gains value (it can unwind or sell protection back at a profit). Duration of CDS (risky PV01) measures sensitivity to spread moves. Understanding these mechanics is foundational for CFA Level II derivatives.

How does a credit default swap actually work from inception to credit event?

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