How does a credit default swap (CDS) work and how is the spread determined?

A credit default swap is a bilateral contract where one party (protection buyer) pays a periodic premium to another party (protection seller) in exchange for compensation if a specified credit event occurs on a reference entity.

Basic Mechanics:

Protection Buyer pays: CDS Spread (in bps per year) x Notional Amount Protection Seller pays: Loss amount if credit event occurs, otherwise nothing

Example: Mapleton Capital buys 5-year CDS protection on Ridgeline Corp:

• Notional: $10 million
• CDS spread: 220 bps per year
• Premium payment: $10M x 2.20$220,000 per year** ($55,000 quarterly)

Mapleton pays $55,000 every quarter. If Ridgeline defaults, the protection seller pays the loss.

Credit Events (Triggers):

1. Bankruptcy — filing for Chapter 7 or 11
2. Failure to pay — missing a scheduled payment beyond the grace period
3. Restructuring — forced modification of debt terms (in some contracts)

Settlement at Credit Event:

Physical settlement: Buyer delivers the defaulted bond, seller pays par ($10M) **Cash settlement:** Seller pays (Par - Recovery Value). If recovery is 40 cents on the dollar: Payment =$10M x (1 - 0.40) = $6.0 million

How the CDS Spread Is Determined:

At inception, the CDS spread is set so that the present value of the premium leg equals the present value of the protection leg:

PV(premiums) = PV(expected loss payments)

The spread reflects:

1. Probability of default — higher PD = wider spread
2. Loss given default — higher LGD = wider spread
3. Term — longer CDS = wider spread (more time for default)
4. Credit curve shape — upward-sloping credit curves mean term spreads

Approximate relationship: CDS Spread ≈ PD x LGD (annualized)

If the market estimates Ridgeline's annual PD at 3.5% and LGD at 60%: Spread ≈ 3.5% x 60% = 2.10% = 210 bps (close to the 220 bps quoted)

Valuing an Existing CDS Position:

If CDS spreads widen after you buy protection, your position gains value (you locked in a lower spread). The mark-to-market value is approximately:

MTM ≈ (Current Spread - Contracted Spread) x Duration x Notional

If Ridgeline's CDS spread widens from 220 to 350 bps and the CDS has an effective duration of 4.2 years: MTM = (350 - 220) x 0.0001 x 4.2 x $10M = 130 x 0.0001 x 4.2 x$10M = $546,000 gain for the protection buyer

CDS vs. Buying/Shorting Bonds:

Feature	CDS	Bond
Upfront capital	Minimal	Full price
Pure credit exposure	Yes	No (also interest rate risk)
Liquidity	Often better	Varies
Counterparty risk	Yes (to protection seller)	No
Can take short credit view	Yes (buy protection)	Difficult

Exam Tip: CDS questions on CFA Level II often test the relationship between CDS spread and bond spread (they should be approximately equal due to arbitrage), and whether a widening spread is good or bad for the protection buyer (good — their position gains value).

Explore credit derivatives in our CFA Level II Fixed Income course.