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CFA® Level II · Fixed Income · free lesson
Credit Default Swaps
Credit default swaps let investors buy or sell credit risk without trading bonds, which makes them central to hedging, relative-value trading and the pricing of credit itself. This module explains how single-name and index contracts are defined, what triggers them and how they settle, how the upfront payment and changes in value follow from spreads and hazard rates, and how practitioners use CDS for hedging, curve trades and basis trades. Level II vignettes mix calculations of upfront payments, settlement amounts and mark-to-market changes with questions that ask you to pick the right trade for a stated view.
What you will learn
1. Describe single-name and index credit default swaps and the terms that define a contract.
- The protection buyer is short credit risk (like shorting the bond); the seller is long credit risk without funding a bond.
- Key terms: reference entity, reference obligation (seniority), notional, standard maturity dates, fixed coupon with upfront payment, ISDA documentation.
- Standard coupons: 1% or 5% in North America; a wider set (for example 0.25%, 1%, 5%, 10%) in Europe; paid quarterly.
- Index CDS (CDX, iTraxx) are equally weighted, roll every six months and are mostly centrally cleared.
- After an index constituent defaults, the seller pays notional/n x (1 - recovery) and the index notional shrinks by 1/n.
2. Explain the credit events that trigger a CDS and how contracts are settled after a credit event.
- Main credit events: bankruptcy, failure to pay and restructuring; sovereigns add repudiation/moratorium and acceleration.
- Standard North American corporate CDS exclude restructuring; European and sovereign contracts include it.
- Determinations Committees decide credit events and succession events; downgrades are not credit events.
- Physical settlement: deliver the cheapest-to-deliver obligation and receive par. Cash settlement: receive par minus recovery.
- Auctions set one final price; payout = notional x (1 - final price), less premium accrued since the last payment date.
3. Explain how CDS are priced, including the upfront payment, and how their value changes as credit spreads move.
- Upfront payment = PV(protection leg) - PV(premium leg at the fixed coupon); paid by the buyer when the spread exceeds the coupon.
- Upfront % ≈ (CDS spread - fixed coupon) x CDS duration; price per 100 = 100 - upfront %.
- Spread ≈ hazard rate x (1 - RR); implied hazard rate ≈ spread / (1 - RR).
- Value change for the buyer ≈ Δspread x duration x notional; the seller has the opposite gain or loss.
- Gains are monetised with an offsetting contract; widening spreads trigger collateral calls on sellers.
4. Explain how CDS are used to manage credit exposure, express views on the credit curve and exploit valuation differences such as basis trades.
- Buy protection to hedge or express a negative view; sell protection for unfunded long credit exposure; index CDS adjust portfolio credit beta quickly.
- Steepening view: buy long-dated, sell short-dated protection; flattening view: the reverse; duration-weight the notionals.
- LBO financed with debt: equity rises, spreads widen, so buy shares and buy protection.
- Basis = CDS spread - bond credit spread; negative basis: buy bond + buy protection; positive basis: sell protection + short bond.
- Basis persists due to funding, liquidity, the cheapest-to-deliver option and counterparty risk.
Module at a glance
- A CDS buyer is short credit risk and pays a fixed coupon; the seller is long credit risk without funding a bond.
- Index CDS (CDX, iTraxx) are equally weighted; a default pays notional/n x (1 - recovery) and shrinks the notional.
- Credit events: bankruptcy, failure to pay, restructuring (not in standard North American corporate contracts); downgrades never count.
- Auctions set one final price; payout = notional x (1 - final price), less accrued premium.
- Upfront ≈ (spread - fixed coupon) x duration, paid by the buyer when positive; price = 100 - upfront %.
- Buyer's gain ≈ Δspread x duration x notional; h ≈ spread / (1 - RR).
- Steepener: buy long-dated, sell short-dated protection; negative basis: buy bond and buy protection.
This free module has 4 lessons, 16 practice questions with full explanations.