Credit Default Swap

A credit default swap works like an insurance policy on a loan or bond. The protection buyer pays a regular premium; if the referenced company (or country) suffers a credit event — fails to pay, restructures, goes bankrupt — the protection seller compensates them for the loss on the debt.

Two things make CDS more than insurance. First, you don't need to own the bond — you can buy protection as a pure bet that a borrower is in trouble, or sell protection to earn premium as a bet that it isn't. Second, CDS trade constantly, so their price — the spread, in basis points per year — is a live ticker of how worried the market is about any name.

When a company's CDS spread jumps from 100 to 400, the market just repriced its survival odds — often faster and more brutally than its bonds or stock.

Standardised mechanics (post-2009 "Big Bang")

• Fixed coupons: contracts pay standardised running coupons (100bp investment grade / 500bp high yield); the difference from the true spread is settled upfront.
• Credit events: bankruptcy, failure to pay, restructuring (region-dependent) — determined by an ISDA Determinations Committee, not by lawsuits.
• Settlement: an auction sets the defaulted debt's recovery price; protection pays (100 − recovery)%.
• Maturity: 5-year is the liquid point; standard roll dates (Mar/Sep 20).

Uses

• Hedging: a bank hedges loan concentrations it cannot sell.
• Shorting credit: buying protection is the practical way to short a bond (borrowing bonds is hard).
• Basis trading: bond spread vs. CDS spread on the same name — the CDS-bond basis converges, mostly.
• Curve trades: 1y vs 5y protection expresses when trouble hits, not just whether.

Pricing: hazard-rate framework

Model default as the first jump of an intensity process \(\lambda_t\); survival \(Q(t) = e^{-\int_0^t \lambda_s ds}\). The par spread equates the premium and protection legs:

yielding the credit triangle \(s \approx \lambda (1-R)\) for flat hazards. Quoting runs through the ISDA Standard Model: flat hazard bootstrapped per tenor with fixed recovery assumption (40% senior), converting spreads ↔ upfronts consistently across the street.

Marking a seasoned position

Value = (current spread − contract coupon) × risky annuity (RPV01, the survival-weighted premium PV). Risk metrics: CS01 (P&L per bp of spread), JTD (jump-to-default: (1−R)·N minus mark), and recovery-rate sensitivity — the three axes of a credit book.

Basis and wrong-way subtleties

The CDS-bond basis reflects funding (bonds need balance sheet; CDS doesn't), the cheapest-to-deliver option in the auction, restructuring-clause differences and repo. Persistent negative basis (bonds cheap vs. CDS) rewards buy-bond-buy-protection packages — until funding stress, as in 2008, blows the convergence trade up. Counterparty wrong-way risk (buying bank protection from a correlated bank) drove the move to central clearing.

Sovereign CDS

Reference sovereign debt with restructuring-heavy event definitions; quanto effects matter (EUR-denominated protection on Italy pays in a currency whose value co-moves with the event) — priced via jump-at-default FX models.