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:

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.