CDS Credit Default Swap: Premium, Settlement, and Basis

Key Takeaways

• The three standard corporate CDS credit events are Bankruptcy, Failure to Pay, and Restructuring; North American contracts typically use No Restructuring, which matters for hedge effectiveness.
• After the 2009 Big Bang, CDS trades use upfront pricing: the buyer pays (market spread minus standard coupon) times Risky PV01 at inception, then pays the standard coupon quarterly.
• On credit event, the ISDA Determinations Committee declares the event and an auction determines the recovery price; settlement is par minus that recovery times the notional.
• Risky PV01 is the present value of 1 basis point of premium weighted by the probability the contract survives to each payment date.

What It Is

A single-name CDS references one corporate or sovereign issuer and a specific class of its debt (usually senior unsecured). The protection buyer pays periodic premium in exchange for a contingent payment. The protection seller receives premium and is obligated to compensate the buyer if an ISDA-defined credit event occurs.

Standard terms are set by the 2014 ISDA Credit Derivatives Definitions. Contracts trade on standard coupons (typically 100 basis points for investment-grade names and 500 basis points for high-yield names) with an upfront payment adjusting for the difference between the standard coupon and the market-implied spread.

The Intuition

A corporate bond bundles interest-rate risk and credit risk. An investor who likes a company's fundamentals but already has too much duration can use CDS to isolate credit exposure. Selling protection gives synthetic exposure to the credit; buying protection hedges default risk on a bond already owned or expresses a bearish credit view without shorting the bond.

Because CDS is a standardized derivative, it is more liquid than the underlying bonds for many names. The CDS-bond basis is the spread difference between cash bond spreads and matched CDS spreads, which measures the dislocation between the two markets.

How It Works

A standard single-name CDS specifies:

• Reference entity and reference obligation (defines the class of debt that counts).
• Notional, tenor (typically 5 years, which is the most liquid point), standard coupon (100 or 500 basis points).
• Credit events that trigger settlement.

For corporate names, the three standard events are Bankruptcy, Failure to Pay, and Restructuring. Restructuring terms vary by region: North America contracts are typically No Restructuring (XR), Europe uses Modified-Modified Restructuring (MMR), and sovereigns use MMR as well (see the sovereign CDS article for detail).

Settlement. After the ISDA Determinations Committee declares a credit event, settlement follows a centralized auction protocol that establishes the final recovery price. The protection buyer then receives:

Settlement = Notional * (1 - auction_recovery_price)

The seller pays that amount and the contract terminates. The 2009 CDS Big Bang and Small Bang protocols introduced auction-based settlement and upfront pricing to replace physical settlement in most cases.

Premium leg. The buyer pays accrued premium on standard dates (20th of March, June, September, December). Because coupons are fixed at 100 or 500 basis points but market spreads move, trades settle with an upfront payment that makes the present value of the two legs equal at inception:

Upfront = (market_spread - standard_coupon) * Risky_PV01

where Risky PV01 is the present value of 1 basis point of premium weighted by survival probability.

Clearing. Index CDS and most liquid single-names clear through central counterparties such as ICE Clear Credit, mandated by post-crisis regulation. DTCC publishes weekly aggregate trade data through its Trade Information Warehouse.

Worked Example

A portfolio manager owns 10 million dollars of Company X 5-year senior unsecured bonds yielding 5.8 percent, and wants to hedge default risk while keeping the coupon.

On the trade date, 5-year CDS on Company X quotes at 220 basis points running spread with a standard 100 basis point coupon. Risky PV01 for that tenor is about 4.5.

Upfront payment: (220 - 100) basis points times 4.5 equals 5.4 percent of notional, or 540,000 dollars paid to the protection seller. After that, the buyer pays 100 basis points annually, split into quarterly 25 basis point payments.

Six months later, Company X files for bankruptcy. ISDA declares the credit event. The auction sets a recovery price of 38 percent. The protection seller pays the buyer (1 - 0.38) times 10 million, equaling 6.2 million dollars. Combined with the bond recovery, the manager's principal is substantially reimbursed.

Common Mistakes

• Forgetting the restructuring clause. A trade booked under XR in North America will not trigger on a distressed debt exchange the way an MMR contract would. Hedge effectiveness depends on matching the clause to the credit view.
• Ignoring the CDS-bond basis. If CDS trades 40 basis points inside cash bond spreads, a bond-plus-protection package has negative carry. The basis must be priced into any hedge decision.
• Assuming linear protection. The CDS spread is not a probability. It embeds risk-neutral default intensity, an assumed recovery (commonly 40 percent for senior unsecured corporates), and liquidity premium. Translating spread directly into default probability without specifying recovery is incorrect.
• Overlooking counterparty risk pre-clearing. Bilateral CDS carries counterparty exposure. After central clearing, initial margin and variation margin reduce this, but uncleared bilateral contracts still exist, especially for less liquid names.
• Confusing running spread with upfront. Post-Big Bang, quoted prices are often upfront points plus a standard coupon. Asking for a quote without specifying coupon convention leads to mispricing.

Frequently Asked Questions

What is the ISDA Determinations Committee and how does it declare a credit event? The Credit Derivatives Determinations Committee is a panel of dealer and buy-side members organized by ISDA that votes on whether a submitted event constitutes a credit event under the relevant CDS definitions. A supermajority vote determines the outcome, and the ruling applies to all outstanding CDS contracts on that reference entity under the same definitions set. The DC also decides technical questions such as whether a restructuring meets the definition and which obligations are deliverable, and it triggers the auction settlement process once a credit event is confirmed.

Why do restructuring clause differences between North America and Europe matter for hedge effectiveness? North American corporate CDS contracts typically use No Restructuring (XR), meaning a distressed debt exchange or out-of-court restructuring does not trigger a credit event. European contracts use Modified-Modified Restructuring (MMR), which includes restructuring as a trigger with deliverability restrictions on long-dated bonds. If a portfolio manager buys XR protection to hedge bonds of a North American issuer that restructures out of court, as opposed to filing for bankruptcy, the CDS will not trigger and the hedge will fail even though the bond has repriced sharply lower. Matching the restructuring clause to the specific scenario expected is critical for hedge design.

How does Risky PV01 differ from regular DV01? Regular DV01 measures the price change of a bond for a one basis point shift in the risk-free yield curve, without accounting for the probability of default. Risky PV01 weights each future premium payment by the probability the CDS contract is still alive to make that payment, discounting out scenarios where the reference entity has already defaulted and the contract terminated. For high-spread credits, Risky PV01 is significantly lower than regular DV01 because there is a substantial probability of early termination. This distinction matters when sizing CDS positions to hedge bond duration, as using regular DV01 over-hedges the credit spread component.

What is the CDS-bond basis and why does it fluctuate? The CDS-bond basis is the difference between the CDS spread and the asset-swap spread on the same issuer's bonds, both measuring credit risk over the same tenor. The basis can be positive (CDS wider than bond spread) or negative (CDS tighter) depending on market conditions. During normal markets, the basis is small because arbitrage keeps the two in line. During stress, the basis can widen dramatically: in 2008, CDS spreads blew out much faster than cash bond spreads as investors rushed to buy protection in the more liquid derivative market, creating large positive bases. For basis traders and hedgers, the CDS-bond basis represents the cost of imperfect hedging and must be monitored continuously.

How does central clearing through ICE Clear Credit reduce counterparty risk in CDS? In a bilateral (uncleared) CDS, both parties face the other's default risk for the life of the contract. When the protection seller fails, as AIG nearly did in 2008, protection buyers face uncompensated losses. Central clearing interposes ICE Clear Credit between buyer and seller: each party's counterparty is now the CCP rather than the original dealer. The CCP requires initial margin to cover potential mark-to-market losses and collects daily variation margin from the losing side to limit accumulated exposure. This eliminates bilateral counterparty risk but concentrates systemic risk at the CCP itself, which is why CCPs are subject to rigorous regulatory stress-testing and default fund requirements.

Sources

1. ISDA. 2014 ISDA Credit Derivatives Definitions. https://www.isda.org/book/2014-isda-credit-derivatives-definitions/
2. ISDA. Credit Derivatives Determinations Committees. https://www.cdsdeterminationscommittees.org/
3. Bank for International Settlements. OTC Derivatives Statistics. https://www.bis.org/statistics/derstats.htm
4. Federal Reserve. Credit Default Swaps and the Financial Crisis (FEDS research). https://www.federalreserve.gov/econres/feds/credit-default-swaps-and-the-financial-crisis.htm
5. Depository Trust and Clearing Corporation. Trade Information Warehouse Public Data. https://www.dtcc.com/repository-otc-data

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.