How do credit default swaps actually work? What happens when a credit event is triggered?

A credit default swap (CDS) is essentially insurance on a bond issuer's credit risk. The protection buyer makes periodic payments (the CDS spread) to the protection seller, who agrees to compensate the buyer if a credit event occurs on the reference entity.

The Structure:

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What Counts as a Credit Event? The standard ISDA definitions include:

1. Bankruptcy — formal legal insolvency filing
2. Failure to pay — missed interest or principal payment beyond any grace period
3. Restructuring — forced modification of bond terms (lower coupon, extended maturity, reduced principal)

For CFA Level II, these three are the ones to know.

Settlement Mechanisms:

Physical Settlement: The protection buyer delivers the defaulted bond (or equivalent deliverable obligation) to the seller and receives par value. If the bond is trading at 35 cents on the dollar, the buyer delivers a bond worth $350,000 per$1 million notional and receives $1,000,000.

Cash Settlement: The seller pays the difference between par and the post-default market value. Using the same example: $1,000,000 -$350,000 = $650,000.

Auction Settlement (most common today): An industry auction determines the recovery rate. All CDS contracts on that reference entity settle at the auction-determined price. This avoids delivery squeezes.

Worked Example: Brighton Asset Management holds $20 million in Meridian Corp bonds. They buy 5-year CDS protection at a spread of 185 bps per year.

• Quarterly premium = $20,000,000 x 0.0185 / 4 = **$92,500 per quarter**
• After 18 months, Meridian files for bankruptcy. Auction determines recovery rate = 28%.
• Cash settlement payment to Brighton = $20,000,000 x (1 - 0.28) = **$14,400,000**
• Brighton also stops paying the quarterly premium.

CDS Pricing Insight: The CDS spread approximately equals the credit spread on the reference entity's bonds. If Meridian's bonds trade at a 190 bps spread over the risk-free rate, the CDS spread should be close to 190 bps. Any deviation creates a basis trade opportunity.

Explore credit derivative strategies in our CFA Level II question bank.