LM05 Credit Default Swaps 2024 Level II Notes

LM05 Credit Default Swaps

1. Introduction ....................................................................................................................................................... 2
2. Basic Definitions and Concepts ................................................................................................................... 2
2.1 Types of CDS ................................................................................................................................................ 3
3. Important Features of CDS Markets and Instruments ....................................................................... 4
3.1 Credit and Succession Events ............................................................................................................... 4
3.2 Settlement Protocols ................................................................................................................................ 5
3.3 CDS Index Products .................................................................................................................................. 6
3.4 Market Characteristics ............................................................................................................................ 7
4. Basics of Valuation and Pricing ................................................................................................................... 8
4.1 Basic Pricing Concepts ............................................................................................................................ 8
4.2 The Credit Curve ........................................................................................................................................ 9
4.3 CDS Pricing Conventions ..................................................................................................................... 10
4.4 Valuation Changes in CDS during Their Lives ............................................................................. 11
4.5 Monetizing Gains and Losses ............................................................................................................. 12
5. Applications of CDS....................................................................................................................................... 12
5.1 Managing Credit Exposures................................................................................................................ 13
6. Valuation Differences and Basis Trading ............................................................................................. 14
Summary ............................................................................................................................................................... 16

This document should be read in conjunction with the corresponding learning module in the 2024
Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All
rights reserved.

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LM05 Credit Default Swaps 2024 Level II Notes

1. Introduction
A credit derivative is a derivative instrument in which the underlying is a measure of a
borrower’s credit quality. There are four types of credit derivatives:
• Total return swaps
• Credit spread options
• Credit-linked notes
• Credit default swaps
Of the four, the focus of this reading is on credit default swaps (CDS). This reading covers
the basic definitions and concepts related to CDS, valuation and pricing of CDS, and
applications of CDS.
2. Basic Definitions and Concepts
What is a CDS?
A credit default swap is a derivative contract between two parties, a credit protection
buyer and a credit protection seller, in which the buyer makes a series of cash payments to
the seller and receives a promise of compensation for credit losses resulting from the
default (i.e., a pre-defined credit event) of a third party.
The exhibit below reproduced from the curriculum shows the structure of payment flows.

Characteristics of a CDS
The characteristics of a CDS are summarized below:
• A CDS is written on the debt of a third party, called the reference entity. The
underlying is the credit quality of a borrower.
• The credit protection buyer is said to be short the reference entity’s credit, i.e. short
the CDS, because he is bearish on the financial condition of the reference entity. The
credit protection seller is said to be long the reference entity’s credit, i.e. long the
CDS, because he is bullish on the financial condition of the reference entity. This
terminology is counterintuitive.

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LM05 Credit Default Swaps 2024 Level II Notes

• CDS protects the buyer against default of a third party. When the default occurs, the
protection buyer stops making payments to the protection seller. The protection
seller instead compensates the protection buyer.
• Credit default swaps are similar to put options.
2.1 Types of CDS
There are three types of CDS: single-name CDS, index CDS, and tranche CDS.
Single-name CDS
A single-name CDS is associated with one specific borrower. The borrower is called the
reference entity. The contract specifies a reference obligation, which is the debt instrument
issued by the borrower and the instrument being covered. The CDS covers any debt
obligation issued by the borrower which is equivalent in priority (pari passu) or higher
relative to the reference obligation.
The payoff on the CDS is determined by the cheapest-to-deliver obligation, which is a debt
instrument that can be purchased and delivered at the lowest cost but has the same
seniority as the reference obligation.
Example
(This is based on Example 1 from the curriculum.)
A company with several debt issues trading in the market files for bankruptcy. What is the
cheapest-to-deliver obligation for a senior CDS contract?
A. A subordinated unsecured bond trading at 20% of par
B. A five-year senior unsecured bond trading at 50% of par
C. A two-year senior unsecured bond trading at 45% of par
Solution:
C is correct. The cheapest-to-deliver, or lowest-priced, instrument is the two-year senior
unsecured bond trading at 45% of par. Although the bond in A trades at a lower dollar
price, it is subordinated and, therefore, does not qualify for coverage under the senior CDS.
Note that even if the CDS holder also held the five-year bonds, he would still receive
payment on the CDS based on the cheapest-to-deliver obligation, not the specific
obligations he holds.
Index CDS
An index CDS allows participants to take positions on the credit risk of a combination of
companies, in the same way that stock indexes allow investors to take equity exposure of a
combination of companies.
The credit correlation among entities in the index impacts the pricing of an index CDS. The
more correlated the defaults, the more costly it is to purchase protection. In contrast, the

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LM05 Credit Default Swaps 2024 Level II Notes

more diversified the companies in the portfolio, the lower the correlation of default, and
the less costly it is to purchase protection.
Tranche CDS
Tranche CDS covers borrowers only up to certain levels of losses, in the same way that
asset-backed securities are divided into tranches, and each tranche covers only a specific
level of losses.
3. Important Features of CDS Markets and Instruments
The important features of CDS markets are listed below:
• ISDA master agreement: ISDA stands for International Swaps and Derivatives
Association (ISDA), which is the unofficial governing body for CDS market. The ISDA
master agreement is a document that lays down the rules that all CDS contracts
must conform to and other guidelines for the functioning of the CDS market. All
parties to a CDS sign the agreement.
• Notional amount: It is the amount of protection being purchased. The notional
amount of a CDS can be greater than the debt outstanding of the reference
obligation.
• Maturity date: A CDS is protected (or covered) up to a certain date known as the
maturity date. It is specified in the contract, and ranges from 1 to 10 years.
• CDS spread: This determines the periodic premium to be paid by the CDS buyer to
the seller. CDS spread or credit spread is a return over Libor to protect against
credit risk. It is based on the credit risk associated with the reference entity.
• Standard coupon rates (usually 1% or 5%): Standardization in the CDS market
has led to the establishment of standard annual coupon rates on CDS contracts: 1%
for investment grade securities and 5% for high-yield securities.
• Upfront payment or premium: The standard rate may not be equal to the CDS
spread. The present value of the differential between the credit spread and the
standard rate is calculated and paid upfront by one of the parities to the contract. If
the credit spread is greater than the standard rate, i.e., the standard rate is
insufficient to compensate for the credit risk, the protection buyer makes an upfront
cash payment to the protection seller. Similarly, if the credit spread is lower than the
standard rate, the protection seller makes an upfront cash payment to the
protection buyer.
3.1 Credit and Succession Events
A credit event is what defines default by the reference entity. When a credit event occurs,
the protection seller makes a payment to the protection buyer.
There are three general types of credit events:

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LM05 Credit Default Swaps 2024 Level II Notes

• Bankruptcy: A bankruptcy filing allows the defaulting party to work with its
creditors and the court to create a repayment plan and likely avoid full liquidation.
• Failure to pay: This occurs when a company has not filed for bankruptcy, but fails
to make a scheduled payment of principal or interest or any outstanding obligation
after a grace period.
• Restructuring: This includes a number of events that alter the terms of the original
issue such as reduction or deferral of interest/principal, change in the seniority of
an obligation, or change in the currency in which principal is scheduled to be paid.
Restructuring may or may not be considered a credit event based on the country. In
the US restructuring is not considered a credit event because US companies typically
prefer the bankruptcy route. Outside the US, restructuring is frequently used by
distressed companies and is considered a credit event.
Determination of a credit event
A 15-member committee, called the determinations committee (DC), within the ISDA
determines if a credit event has occurred. Each region of the world has a DC. A super
majority vote of 12 members is required to declare an event as a credit event.
DC also plays a key role in determining whether a succession event has occurred.
Succession events arise when there is a change in corporate structure such as mergers,
spin-offs, divestiture, etc. If a succession event has occurred, the DC identifies the party that
will oblige the original debt.
3.2 Settlement Protocols
If the DC confirms a credit event has occurred, the two parties to a CDS have the right to
settle, but no obligation. Settlement occurs 30 days after declaration of the credit event by
DC. There are two ways to make a settlement:
• Physical settlement: The debt instrument (reference obligation) is delivered by the
protection buyer to the protection seller in exchange for a payment equal to the
notional amount of the CDS contract.
• Cash settlement: The credit protection seller pays cash to the credit protection
buyer. The payout amount is the payout ratio multiplied by the notional amount.
The payout ratio is an estimate of the expected credit loss and depends on the
recovery rate. The reference entity’s cheapest to deliver debt obligation is
auctioned, and the proportion of par that the bonds trade at is used as a proxy for
the actual recovery rate.
The formulas for payout ratio and payout amount are given below:
Payout amount = Payout ratio * notional amount
Payout ratio = 1 – recovery rate (%)

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LM05 Credit Default Swaps 2024 Level II Notes

Example
(This is based on Example 2 from the curriculum.)
A company files for bankruptcy, triggering a credit event. It has two series of senior bonds
outstanding: Bond A trades at 30% of par, and Bond B trades at 40% of par. Investor X
owns €10 million of Bond A and owns €10 million of CDS protection. Investor Y owns €10
million of Bond B and owns €10 million of CDS protection.
1. Determine the recovery rate for both CDS contracts.
2. Will Investor X prefer a cash settlement or physical settlement?
3. Will Investor Y prefer a cash settlement or physical settlement?
Solution to 1:
Bond A is the cheapest-to-deliver obligation, trading at 30% of par, so the recovery rate for
both CDS contracts is 30%.
Solution to 2:
Investor X has no preference between settlement methods. She can cash settle for €7
million [(1 – 30%) × €10 million] and sell her bond for €3 million, for total proceeds of €10
million. Alternatively, she can physically deliver her entire €10 million face amount of
bonds to the counterparty in exchange for €10 million in cash.
Solution to 3:
Investor Y would prefer a cash settlement because he owns Bond B, which is worth more
than the cheapest-to-deliver obligation. He will receive the same €7 million payout on his
CDS contract, but can sell Bond B for €4 million, for total proceeds of €11 million. If he
were to physically settle his contract, he would receive only €10 million, the face amount of
his bond.
3.3 CDS Index Products
‘Markit Indexes’, named after the company that produces CDS indexes, are classified by
regions and further classified by credit quality. North America and Europe are the two
commonly traded regions. North American indexes are identified by the symbol CDX, and
European, Asian, and Australian indexes are identified as iTraxx.
Within each region, the indexes are classified as investment-grade and high-yield indexes
as listed below:
• CDX IG: equally weighted portfolio of 125 investment grade North American
companies
• CDX HY: comprising 100 high yield North American companies
• iTraxx Main: comprising 125 investment grade entities
• iTraxx Crossover: comprising 50 high yield entities

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LM05 Credit Default Swaps 2024 Level II Notes

All CDS indexes are equally weighted, i.e., if there are 125 entities in the index, the notional
principal attributable to each entity = Total notional principal of the index / 125
The indexes are updated every six months. The new series is called the on-the-run series,
while the older ones are called off-the-run series. Index CDS are typically more liquid and
have higher trading volume than single-name CDS.
Example:
(This is Example 3 from the curriculum.)
Assume that an investor sells $500 million of protection on the CDX IG index. Concerned
about the creditworthiness of a few of the components, the investor hedges a portion of the
credit risk in each. For Company A, he purchases $3 million of single-name CDS protection,
and Company A subsequently defaults.
1. What is the investor’s net notional exposure to Company A?
2. What proportion of his exposure to Company A has he hedged?
3. What is the remaining notional on his index CDS trade?
Solution to 1:
The investor is long $4 million notional ($500 million/125) through the index CDS and is
short $3 million notional through the single-name CDS. His net notional exposure is $1
million.
Solution to 2:
He has hedged 75% of his exposure ($3 million out of $4 million).
Solution to 3:
His index CDS has $496 million remaining notional.
3.4 Market Characteristics
Banks or lenders face two primary risks when lending a corporate loan:
• Credit risk or default risk: the risk that the borrower will not repay principal or
interest.
• Interest rate risk: risk that the lender will not earn equivalent to other instruments
in the market because interest rates have changed.
Credit derivatives are used to manage credit risk by transferring the risk of non-payment to
a third party. CDS transactions are executed in the OTC market by phone, instant message,
and Bloomberg message service. Trade information is reported to the Depository Trust and
Clearinghouse Corporation, which is a U.S. headquartered entity providing post-trade
clearing, settlement, and information services for many kinds of securities in addition to
asset custody and asset servicing.

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LM05 Credit Default Swaps 2024 Level II Notes

New regulations require most CDS transactions to be centrally reported and cleared
through a clearinghouse, which collect and distribute payments and impose margin
requirements, as well as mark positions to market. This ensures that a considerable
amount of systemic risk is eliminated.
4. Basics of Valuation and Pricing
Note: This section is important from a testability perspective.
Pricing a CDS means determining the CDS spread or upfront payment given a particular
coupon rate for a contract. Pricing a CDS is challenging relative to pricing other derivatives
because the underlying is credit risk, which is not explicitly traded.
4.1 Basic Pricing Concepts
In this section, let us understand some basic CDS pricing concepts.
• Probability of default/Hazard rate: Probability of default is the probability of
non-payment of an upcoming interest or principal obligation in a given year. Since
CDS typically cover a multi-time horizon, the probability of default is not constant
and it usually increases over longer time periods. In the CDS context, we are
interested in the conditional probability of default called the hazard rate. The hazard
rate is the probability that an event will occur given that it has not already occurred.
Once the event occurs, there is no further possibility of its occurrence.
• Probability of survival: Given the hazard rate, the probability of survival is
calculated as (1 – hazard rate).
• Loss given default: The amount that will be lost if a default occurs.
• Expected loss: It is the full amount owed minus the expected recovery.
Expected loss = loss given default ∗ probability of default
There are two kinds of payments or two sides in a CDS contract that determine the
valuation of a CDS:
• Premium leg: One is a series of payments from the protection buyer to the
protection seller until default occurs.
• Protection leg: Contingent payment the credit protection seller makes to the credit
protection buyer when a default occurs.
• Upfront payment: It is the difference in the value of the protection leg and
premium leg.
Upfront payment = present value of protection leg − present value of premium leg
The party having a greater present value makes an upfront payment to the counterparty.

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LM05 Credit Default Swaps 2024 Level II Notes

Example
(This is based on Example 4 from the curriculum.)
Assume that a company’s hazard rate is a constant 8% per year, or 2% per quarter. An
investor sells five-year CDS protection on the company with the premiums paid quarterly
over the next five years.
1. What is the probability of survival for the first quarter?
2. What is the conditional probability of survival for the second quarter?
3. What is the probability of survival through the second quarter?
Solution to 1:
Probability of survival for the first quarter = 100% - hazard rate = 100% - 2% = 98%.
Solution to 2:
The conditional probability of survival for the second quarter is also 98%, because the
hazard rate is constant at 2%. In other words, conditional on the company having survived
the first quarter, there is a 2% probability of default in the second quarter.
Solution to 3:
Probability of survival through the two quarters = probability of survival in the first
quarter * probability of survival in the second quarter = 98% x 98% = 96.04%. The
probability of default = 1 − 0.982 = 3.96%
4.2 The Credit Curve
The credit spread of a debt instrument is the rate in excess of LIBOR that investors expect
to receive to justify holding the instrument. It is roughly equal to the probability of default
multiplied by the loss given default. The credit curve represents credit spreads for a range
of maturities of a company’s debt. It is similar to the term structure of interest rates.
The credit curve is determined by CDS rates and is affected by a number of factors
including the hazard rate.
• A flat credit curve implies a constant hazard rate.
• An upward slowing curve implies a greater likelihood of default in later years.
• A downward-sloping credit curve implies a greater probability of default in earlier
years.
Example
(This is based on Example 5 from the curriculum.)
A company’s 5-year CDS trades at a credit spread of 300 bps, and its 10-year CDS trades at
a credit spread of 500 bps.

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LM05 Credit Default Swaps 2024 Level II Notes

1. The company’s 5-year spread is unchanged, but the 10-year spread widens by 100 bps.
Interpret this change.
2. The company’s 10-year spread is unchanged, but the 5-year spread widens by 500 bps.
Interpret this change.
Solution to 1:
This change implies that although the company is not any riskier in the short term, its
longer-term creditworthiness is less attractive. Perhaps the company has adequate
liquidity for the time being, but after five years it must begin repaying debt or it will be
expected to have cash flow difficulties.
Solution to 2:
This change implies that the company’s near-term credit risk is now much greater. In fact,
the probability of default will decrease if the company can survive for the next five years.
Perhaps the company has run into liquidity issues that must be resolved soon, and if not
resolved, the company will default.
4.3 CDS Pricing Conventions
CDS prices are often quoted as credit spreads because they are much more informative
than their absolute prices. The convention in the CDS market for the fixed payments made
from the CDS buyer to the CDS seller is to use standardized coupons of 1% for investment-
grade debt or 5% for high-yield debt. If the credit spread of the reference obligation is
different from these rates, then an upfront payment is made from one party to the other.
Upfront premium = Present value of credit spread – Present value of fixed coupon
Rearranging the formula, we get:
Present value of credit spread = Upfront premium + Present value of fixed coupon
A good approximation of the present value of a stream of payments can be made by
multiplying the payment rate by the duration:
Upfront premium ≈ (Credit spread − Fixed coupon) ∗ Duration
Upfront premium
Credit spread ≈ + Fixed coupon
Duration
Price of CDS in currency per 100 par = 100 − Upfront premium%
Upfront premium % = 100 − price of CDS in currency per 100 par

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LM05 Credit Default Swaps 2024 Level II Notes

Example
(This is based on Example 6 of the curriculum.)
1. Assume a high-yield company’s 10-year credit spread is 600 bps, and the duration of
the CDS is eight years. What is the approximate upfront premium required to buy 10-
year CDS protection? Assume high-yield companies have 5% coupons on their CDS.
2. Imagine an investor sold five-year protection on an investment-grade company and had
to pay a 2% upfront premium to the buyer of protection. Assume the duration of the
CDS to be four years. What are the company’s credit spreads and the price of the CDS
per 100 par?
Solution to 1:
Upfront premium = (Credit spread − Fixed coupon) ∗ Duration
Upfront premium = (600 – 500)*8 = 8% of notional
Solution to 2:
The sign of the upfront premium is negative because the seller is paying the premium
rather than receiving it. This happens when the credit spread is less than the fixed coupon.
Upfront premium −200
Credit spread ≈ + Fixed coupon ≈ + 100 = 50 bps
Duration 4
Price of CDS per 100 par = 100 − Upfront premium% = 100 − (−2) = 102
4.4 Valuation Changes in CDS during Their Lives
The value of a CDS changes during its lifetime because of several factors such as change in
duration, probability of default, expected loss given default, and the shape of the credit
curve.
Market participants constantly assess the credit quality of the reference entity to determine
its current value and the implied credit spread. Any new information received is used to
estimate new values using a valuation model.
For example, if during the life of the CDS, the credit quality of the reference entity
improves, then the credit spread narrows. This will benefit the protection seller because he
continues to receive the same compensation from the protection buyer, but bears less risk.
Similarly, a protection buyer benefits when the credit spread widens.
The change in the value of CDS for a given change in spread can be approximated by the
formula:
Profit for the buyer of protection ≈ Change in spread in bps ∗ Duration ∗ Notional
% Change in CDS price = Change in spread in bps ∗ Duration

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LM05 Credit Default Swaps 2024 Level II Notes

Example
(This is based on Example 7 from the curriculum.)
An investor buys $10 million of five-year CDS protection, and the CDS contract has a
duration of four years. The company’s credit spread was originally 500 bps and widens to
800 bps.
1. Does the investor (credit protection buyer) benefit or lose from the change in credit
spread?
2. Estimate the CDS price change and estimated profit to the investor.
Solution to 1:
The investor owns protection, so he is economically short and benefits from an increase in
the company’s credit spread. He can sell the protection for a higher premium.
Solution to 2:
% Change in CDS price = Change in spread in bps ∗ Duration = 300 ∗ 4 = 12%
Profit for the buyer of protection ≈ 12% ∗ Notional = 12% ∗ $10 million = $1.2 million
4.5 Monetizing Gains and Losses
Monetizing is the process of realizing a gain or loss as the market value of CDS changes. As
the borrower’s credit quality changes through time, the market value of the CDS changes,
giving rise to gain or loss for CDS counterparties.
The counterparties can realize those gains or losses by entering into new offsetting
contracts which match the terms of the original CDS. If the credit quality of the original CDS
had improved, then original protection buyer monetizes a loss because the upfront
premium paid earlier was higher than what he receives now. The original protection seller
monetizes a gain.
Another monetizing method is to exercise the CDS in response to a default.
The third and least common method is for the protection seller to hold the position till
expiration. The protection buyer pays all the premiums to the protection seller until
expiration; the seller is not obligated to make any payments after expiration. The seller
gains in this method and the buyer loses.
5. Applications of CDS
Any derivative instrument has two general uses: to exploit an expected movement in the
underlying and to take advantage of any valuation differences between the derivative and
the underlying.
These two general uses are also the two major applications of CDS: managing credit
exposure and taking advantage of valuation differences. We will see both of them in detail

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LM05 Credit Default Swaps 2024 Level II Notes

below:
5.1 Managing Credit Exposures
The main objective of using a CDS is to increase or decrease credit exposure.
A lender buys a CDS to reduce credit exposure to a borrower.
A seller may trade in CDS to make profits from making markets as a dealer. An investor
who is keen on taking only credit risk and not interest rate risk may sell CDS. Recall that
when one buys a bond, there is both credit risk and interest rate risk. CDS is more liquid,
and selling a CDS requires less capital and has low transaction costs.
Naked credit default swap: A credit protection position taken by a party with no exposure
to the reference entity is called a naked credit default swap. The protection buyer takes
such a position in the belief that the credit quality of the reference entity will deteriorate,
while the seller believes it will improve.
The different CDS trading strategies include:
• Long/short trade: This involves taking a long position in one CDS and a short
position in another CDS. The reference entities for the two CDS are different, but
may be related in some way. This transaction is a bet that the credit position of one
entity will improve relative to the other entity. An investor may also undertake a
long/short trade based on other factors such as environmental, social and
governance (ESG) factors.
• Curve trade: This involves buying a CDS of one maturity and selling CDS on the
same reference entity with a different maturity.
Shape of the credit curve: The credit curve may become steeper or flatter. A steeper
curve implies that the long-term credit risk increases, while a flatter curve implies
the risk is higher in the short-term. For a stepper credit curve, an investor can go
short (buy protection) a long-term CDS and long (sell protection) a short-term CDS.
Level of the credit curve: For an equal shift in the level of the credit curve, the long-
term CDS will be more sensitive than short-term CDS.
Example
(This is Example 9 from the curriculum.)
An investor owns some intermediate-term bonds issued by a company and has become
concerned about the risk of a near-term default, although he is not very concerned about a
default in the long term. The company’s two-year duration CDS currently trades at 350 bps,
and the four-year duration CDS is at 600 bps.
1. Describe a potential curve trade that the investor could use to hedge the default risk.

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LM05 Credit Default Swaps 2024 Level II Notes

2. Explain why an investor may prefer to use a curve trade as a hedge against the
company’s default risk rather than a straight short position in one CDS.
Solution to 1:
The investor anticipates a flattening curve and can exploit this possibility by positioning
himself short (buying protection) in the two-year CDS while going long in the four-year
CDS (selling protection).
Solution to 2:
Going short one CDS and long another reduces some of the risk because both positions will
react similarly, although not equally, to information about the reference entity’s default
risk. Moreover, the cost of one position will be partially or more than wholly offset by the
premium on the other.
6. Valuation Differences and Basis Trading
Valuation differences in CDS arise because of the different opinions of the price of credit
risk.
A bond has both credit risk and interest rate risk. The basic premise is that the amount of
yield attributable to the credit risk on a bond should be equal to the credit spread on a CDS
(credit spread = CDS spread). But, in reality, it is possible that the credit spread implied by
the bond market is different from the credit spread implied by the CDS market. A difference
in the credit spread in these two markets leads to a strategy known as a basis trade.
By exploiting any temporary mispricing between the two markets, an investor can capture
a gain as the spreads eventually converge.
Bond yield can be decomposed into the following:
Bond yield = risk-free rate + funding spread + credit spread
where: risk-free rate + funding spread = Libor
Rearranging, we get the formula for credit spread as:
Credit spread = Yield – Libor
If the spread is higher in the bond market than the CDS market, it is said to be a negative
basis.
Example:
(This is Example 10 from the curriculum.)
An investor wants to be long the credit risk of a given company. The company’s bond
currently yields 6% and matures in five years. A comparable five-year CDS contract has a
credit spread of 3.25%. The investor can borrow in the market at a 2.5% interest rate.

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LM05 Credit Default Swaps 2024 Level II Notes

1. Calculate the bond’s credit spread.

2. Identify a basis trade that would exploit the current situation.
Solution to 1:
The bond’s credit spread is equal to the yield (6%) minus the investor’s cost of funding
(2.5%). Therefore, the bond’s credit spread is currently 3.5%.
Solution to 2:
The bond and CDS markets imply different credit spreads. Credit risk is cheap in the CDS
market (3.25%) relative to the bond market (3.5%). The investor should buy protection in
the CDS market at 3.25% and go long the bond with its 3.5% credit spread, netting 25 bps.
Leveraged buyouts: If a company undergoes a leveraged buyout (LBO), it will issue large
amounts of debt and use the proceeds to repurchase all of its publicly traded equity. This
additional debt will increase the probability of default and thus increase its CDS spread. An
investor anticipating an LBO can purchase both the stock of the company and CDS
protection. If an LBO occurs, both legs will earn a profit.
CDS indexes: The value of the index should be equal to the sum of the values of the index
constituents. If this is not the case, an arbitrage opportunity exists and the investor can go
long the cheaper instrument and go short the more expensive instrument.

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LM05 Credit Default Swaps 2024 Level II Notes

Summary
LO: Describe credit default swaps (CDS), single-name and index CDS, and the
parameters that define a given CDS product.
A credit default swap is a derivative contract between two parties, a credit protection
buyer and a credit protection seller, in which the buyer makes a series of cash payments to
the seller and receives a promise of compensation for credit losses resulting from the
default, i.e. a pre-defined credit event, of a third party.
A single-name CDS is associated with one specific borrower. The borrower is called the
reference entity.
An index CDS allows participants to take positions on the credit risk of a combination of
companies.
LO: Describe credit events and settlement protocols with respect to CDS.
A credit event is an event that defines default by the reference entity, which triggers a
payoff by the seller to the buyer of the CDS. The three types of credit events include
bankruptcy, restructuring, and failure to pay.
Settlement of a CDS can happen either through physical settlement or cash settlement.
LO: Explain the principles underlying, and factors that influence the market’s pricing
of CDS.
Pricing a CDS means determining the CDS spread or upfront payment given a particular
coupon rate for a contract.
Valuation of a CDS is determined by the difference in the present value of the protection leg
and the present value of the premium leg. The party with the greater present value makes a
payment to the counterparty.
Upfront payment = present value of protection leg − present value of premium leg
The change in the value of CDS for a given change in spread can be approximated by the
formula:
Profit for the buyer of protection ≈ Change in spread in bps ∗ Duration ∗ Notional
% Change in CDS price = Change in spread in bps ∗ Duration
LO: Describe the use of CDS to manage credit exposures and to express views
regarding changes in the shape and/or level of the credit curve.
Naked credit default swap: A credit protection position taken by a party with no exposure
to the reference entity is called a naked credit default swap. The protection buyer takes
such a position in the belief that the credit quality of the reference entity will deteriorate,
while the seller believes it will improve.

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LM05 Credit Default Swaps 2024 Level II Notes

Long/short trade: This involves taking a long position in one CDS and a short position in
another CDS. The reference entities for the two CDS are different, but may be related in
some way. This transaction is a bet that the credit position of one entity will improve
relative to the other entity.
Curve trade: This involves buying a CDS of one maturity and selling CDS on the same
reference entity with a different maturity. If the credit curve is expected to flatten, then an
investor should buy protection in a CDS in the short-term to hedge the default risk, and sell
protection in the long-term. For a stepper credit curve, an investor can go short (buy
protection) a long-term CDS and long (sell protection) a short-term CDS.
LO: Describe the use of CDS to take advantage of valuation disparities among
separate markets, such as bonds, loans, equities, and equity-linked instruments.
CDS are used to capitalize on different assessments of the cost of credit among different
instruments tied to the reference entity such as debt, equity, and derivatives of debt and
equity.
A difference in the credit spread on a bond implied by the bond market and CDS markets
leads to a strategy known as a basis trade.

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