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PRIMERS

The derivative at the heart of modern credit risk transfer.

JUN 15, 2025

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For all the focus on bond yields, equity volatility, and economic growth, the
market’s clearest view on credit risk trades in a more specialised arena: the CDS
market.

Short for Credit Default Swaps, CDS are derivative contracts that function like
insurance on corporate or sovereign debt. They allow investors to hedge against
default, speculate on credit deterioration, or construct relative value trades across
the capital structure. In many cases, they serve as the most liquid expression of
credit risk—more responsive than cash bonds, and more versatile than credit
ETFs.

CDS markets are used by banks, hedge funds, insurance companies, asset
managers, and macro desks. They play a critical role in price discovery, risk
transfer, and credit portfolio construction. And during stress events, they o�en
move before anything else does.

This primer walks through:

- CDS basics (mechanics, pricing)

- The role of CDS in hedging and trading
- Credit curves, capital structure arbitrage, and basis trades

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- Key participants and use cases

- Notable dislocations and blowups
- Why CDS matters for market structure and liquidity

If you like FX basis, STIRs, or convexity in obscure derivatives, you’ll enjoy this
one. If you don’t, well, this is how the big players hedge credit risk. It’s worth
understanding.

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At its core, a Credit Default Swap (CDS) is a bilateral derivative contract designed

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to transfer credit risk. One party (the protection buyer) pays a periodic premium to
another party (the protection seller) in exchange for compensation if a prede�ned
credit event occurs 1.

The CDS is settled against a reference entity (a corporation or sovereign) and

applies to a reference obligation, usually a speci�c bond issued by that entity. If
the entity defaults, the protection seller compensates the buyer by delivering the
defaulted bond (physical settlement) or paying the loss value (cash settlement).

CDS contracts are usually quoted in basis points (bps) per annum on the notional
amount of protection. The wider the spread, the higher the reference entity’s
perceived credit risk.

For example, let’s take an investment-grade rated corporation, JP Morgan. The

chart (in bps) of a �ve-year CDS is below. The �ve-year maturity is widely
considered the benchmark for pricing and liquidity in general in the CDS market.

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The �ve-year is trading just above 43bps. This means that for every $1m notional
bought, a 0.43% premium is paid annually. In reality, this premium accrues and is
typically paid quarterly.

If JPM defaults within this period and the bond recovers at 40 cents on the dollar,
the CDS pays out $600k (i.e., $1m × (1 – 0.40)).

JPM has a relatively low CDS spread, with the payo� versus annual premiums
being considerably di�erent. However, consider the historical �ve-year period for
Carnival Cruises. In the a�ermath of the pandemic, there was serious concern that

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the lockdowns and lack of travel could put the operator out of business.

In late 2022, the spread spiked above 20%, implying that the annual premium
equated to one-��h of the notional payout in the event of default. This sharp

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widening re�ected heightened market concern around credit risk.

The �ve-year CDS is also a useful tool for comparing company creditworthiness.
Although Carnival is currently operating under normal conditions, its spread
remains elevated at 147bps, nearly four times that of JPM.

One might consider shorting the �rm’s bonds to express a similar bearish credit
view. While this approach can work in certain contexts, it’s important to contrast
the two instruments to understand the di�erences in exposure, liquidity, and
execution.

CDS vs. Bonds

CDS o�ers a purer and o�en more liquid expression of credit risk than the cash
bond market. It isolates the default component, stripping out interest rate
duration, repo �nancing, and coupon variability.

Because CDS contracts are standardised and trade over-the-counter (with central
clearing increasingly common), they are more �exible instruments for hedging,
especially when it comes to building or managing credit exposure across a
portfolio.

Another key di�erence is speed. CDS spreads o�en move more rapidly than bond

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prices. In periods of market stress, traders tend to reach for CDS as the �rst
instrument to price in credit risk, driven not only by liquidity but also by the
e�ciency and clarity of expressing directional views.

While bonds represent long exposure to credit (providing repayment unless the
issuer defaults), CDS �ip the structure. Buying CDS constitutes a short credit risk
position, with the buyer pro�ting if the reference entity deteriorates or defaults.
Conversely, selling CDS creates long credit risk exposure, in which the seller
receives premium income in exchange for assuming the risk of a credit event.

This asymmetric payo� structure makes CDS a critical tool for hedging long bond
positions, constructing macro strategies around credit cycles, or isolating
idiosyncratic credit risk at the single-name level.

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At its core, a CDS contract is an insurance agreement. The buyer of protection

pays a regular premium; the seller receives that income in exchange for assuming
default risk.

There are two main legs to a CDS trade:

- Premium Leg: The protection buyer pays a regular premium (quarterly, in most
cases) for the life of the contract or until a credit event occurs.

- Protection Leg: If a credit event occurs, the seller compensates the buyer,
typically by paying the di�erence between par and the post-default recovery value
of the reference bond.

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CDS Spreads and Premiums:

As mentioned above with JPM, on a $1m notional, that’s circa $43k per year or
$10.75k per quarter. If no credit event occurs during the contract’s life, the seller
keeps the premium, and the contract expires.

But unlike �xed-rate bond coupons, CDS premiums aren’t baked into the upfront
price. The contract is marked to market daily, and values �uctuate based on
spread movements, just like a bond or interest rate swap.

CDS spreads are also widely used in credit risk modelling, counterparty valuation
adjustment (CVA), and pricing of structured credit products. The implied
probability of default embedded in the spread provides a key input across trading,
risk, and capital modelling functions.

To best explain the following points, we’re going to base it on the deal screen for
the JPM CDS.

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Upfront Payments and Credit Curves:

For investment-grade CDS (where spreads are relatively low), contracts typically
trade close to par. This means the upfront payment is pretty minimal; the spread
itself represents the market’s view of credit risk. In the case of JPM, the price is
trading above par at 102.47. This means the CDS has positive value to the seller.

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For high-yield or distressed names, spreads can be hundreds or even thousands of

basis points. In these cases, the CDS may require a much larger upfront payment
at inception to account for the fact that the contractual coupon (usually �xed at
100bps or 500bps, depending on the market convention) is lower than the actual
market-implied risk.

In the deal screen, the standard coupon is shown as 100bps.

To clarify, the premium leg is �xed, but the upfront cost adjusts the trade to fair
value based on prevailing market spreads.

Credit curves are typically upward sloping—that is, longer-dated CDS contracts
tend to trade at wider spreads. As illustrated in the bottom-right chart, the JPM
curve adheres to this convention. However, as with yield curves, credit curves can
invert under stress, particularly when short-term default risk rises sharply.

An inverted credit curve can also signal dislocation in near-term funding

conditions or elevated concern over default within a speci�c time horizon—
insights not always captured in cash bond curves.

The deal screen also displays a purple cash amount of $27,000. This �gure re�ects
the combination of the principal di�erence (current price - par value x notional)
and accrued premium. Together, these components determine the total upfront

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cash payment.

The Credit Event and Settlement Process:

If the reference entity defaults, the CDS pays out. But not all “bad news” triggers a
credit event. The rules are strict, codi�ed by ISDA (International Swaps and
Derivatives Association), and standardised across contracts.

There are three main credit event types:

- Bankruptcy
- Failure to Pay
- Restructuring

Once a credit event is con�rmed, the CDS is settled in one of two ways:
- Physical Settlement: The protection buyer delivers an eligible bond (or loan) and
receives par from the seller.
- Cash Settlement: More common in recent years. The CDS is settled based on the
recovery rate, determined through an auction process overseen by ISDA.

The ISDA auction process has become the standard settlement method across
most CDS markets. It establishes a transparent and consistent recovery rate,
ensuring both buyers and sellers can exit with de�ned outcomes.

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Recovery Rates and Payouts:

In the case of a credit event, the payout to the protection buyer equals the
di�erence between the notional and the recovery value of the reference obligation.

Payout = Notional × (1 − Recovery Rate)

If a $1m CDS triggers and the recovery rate is 40%, the protection seller pays the
buyer $600k.

Recovery assumptions are a key input into CDS pricing models. For IG names,
recovery is o�en assumed around 40%, while HY names might price with a lower
implied recovery (20–30%), depending on market conditions and debt seniority.
This impacts the default exposure.

Default Exposure = (1- Recovery Rate) x Notional - Principal

The deal screen can toggle the recovery rate from the standard 0.40. Note that the
higher the recovery rate, the lower the default exposure becomes:

0.4 RR

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0.7 RR

This is logical and shows how the bond’s creditworthiness is factored in multiple
ways when breaking down a CDS.

The market-implied CDS spread pricing is essentially the cost of insuring a bond
against default, adjusted for the probability of default and expected recovery.

Mathematically: CDS Spread ≈ Probability of Default × (1 − Recovery Rate)

This identity holds at the core of CDS valuation and is a common shortcut used in
the front o�ce to estimate fair spread levels quickly. In reality, CDS pricing also

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re�ects liquidity conditions, dealer positioning, and counterparty risk, but the
spread-recovery-default triangle remains the bedrock.

CDS contracts were designed initially as hedging tools. Over time, they evolved
into active trading instruments used across credit markets, from directional views
to structured arbitrage.

Hedging Credit Exposure:

The most straightforward application of CDS is to hedge bond holdings. Example:

Consider a portfolio holding corporate bonds issued by JP Morgan. If the investor
is comfortable with the interest rate exposure but concerned about potential
spread widening or default risk, buying CDS protection on the bank o�ers a direct
hedge. This approach avoids the need to sell the bonds (which may be illiquid, tax-
ine�cient, or operationally di�cult to replace) while isolating and mitigating the
credit risk component.

Doing so converts a credit-sensitive bond into something closer to a risk-free

asset. The mark-to-market changes in the bond and the CDS should (in theory)
o�set each other as credit spreads move.

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Look at how a drop in the price of the 2030 JPM bond saw a corresponding spike
in the CDS:

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Hedging via CDS is common among asset managers, insurance �rms, and banks,
especially under capital frameworks like Basel III, where credit risk charges can
be actively managed through CDS overlays.

Speculating on Credit Moves:

Just as CDS can hedge a long bond, they can also be used to take a view on credit
deterioration or improvement:

- Bullish on credit: Sell CDS, collect premium, and hope no credit event occurs.
- Bearish on credit: Buy CDS, and pro�t if spreads widen or the reference entity
defaults.

Because CDS spreads are quoted in basis points of annual premium, the mark-to-
market sensitivity of a CDS position is straightforward. The P&L from spread
moves is easy to calibrate for a given notional amount, making CDS an e�cient
instrument for short-term tactical trades or long-term macro themes.

Capital Structure Arbitrage:

CDS can also express relative value views across an issuer’s capital structure. One
common strategy involves going long the equity of a company while
simultaneously buying CDS protection on its debt. This setup allows a trader to

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isolate discrepancies between how equity and credit markets price the same
underlying risk.

In theory, equity holders are junior to debt holders in the capital structure and
should demand a higher return (and price in more risk). But in practice, markets
o�en diverge, particularly in volatile or distressed environments. When credit
spreads widen sharply while equity prices hold �rm (or vice versa), it can signal
mispricing between asset classes.

Example: Let’s say JP Morgan is going through a stress event, and a trader might
feel the bond market has overreacted to default risk, while equity markets are
pricing in a faster recovery. A trader might fade the panic-driven CDS widening
with equity puts in those cases. If they’re correct, they’ll pro�t from tightening the
spread, but give up some of the total gains from losses from the puts. In reality, it
becomes a market-neutral trade that aims to target pricing ine�ciencies across
the capital stack (credit views relative to equity sentiment).

Basis Trades:

Another strategy in CDS markets is the basis trade. We’ve written about this
before in other asset classes, for example, in STIR markets.

For our speci�c case, we’re talking about exploiting the spread di�erence between

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a CDS and its reference bond. In theory, a bond’s credit spread should match the
CDS premium (a�er adjusting for technical factors like accruals, curve, and repo
funding).

But in practice, this relationship breaks down, especially during market stress,
funding squeezes, or index roll periods. Traders take advantage by buying the
cheaper of the two and selling the richer leg, locking in a spread that converges
over time.

Let’s consider Carnival again, with a bond maturing in about �ve years. The
screenshot below shows the spread analysis, with a 159bps yield over the
corresponding US Treasury.

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The �ve-year CDS is at 155bps, which is basically the same as the spread versus
the Treasury when factoring in technical factors.

Yet for argument’s sake, let’s assume the CDS was trading at 100bps all in, making
the bond’s credit spread higher than the CDS. A trader might buy the bond and
simultaneously sell CDS protection, capturing the positive basis as carry and
expecting the spread di�erence to tighten over time.

Curve Trading:

Credit curves, like yield curves, are not always linear. Take a look at the curve
below for Apple, which shows a steeper gradient in the 2-5 year space while
�attening out in the longer term.

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CDS traders o�en take curve views by going long one tenor (e.g., 5-year CDS) and
short another (e.g., 10-year CDS) on the same reference entity.

A mix of institutional players drives the CDS market, but dealers and hedge funds
are the most active and in�uential participants. Other entities, such as asset
managers, insurers, and corporates, engage in more selective or secondary roles.

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Dealers and Banks are the primary liquidity providers. They make markets in
both single-name and index CDS, manage client �ow, and warehouse credit risk.
CDS desks typically sit within credit trading or macro businesses and o�en
balance directional views with hedging needs. Interdealer activity also helps set
pricing benchmarks, especially around index rolls and event-driven situations.

Hedge Funds are active across speculative and relative value strategies. They use
single-name CDS for outright credit views, index CDS to express macro themes,
and structured trades like curve steepeners, basis arbitrage, and distressed-event
setups. Some funds also trade CDS volatility via options on indices (swaptions), or
overlay CDS on equity long/short portfolios as synthetic hedges.

Asset Managers and Pension Funds use CDS more selectively, o�en in large
notional sizes for risk management. Index CDS is the most common tool for
hedging portfolio exposure or expressing macro credit views. Some also sell
protection on high-grade names to enhance yield, particularly in low-volatility,
low-rate environments.

Insurers and Credit Guarantors were once major protection sellers, but their role
has become more limited since the 2008 crisis. Today, their activity is more
conservative and typically involves capital relief trades or tailored credit risk
transfer structures.

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Corporates and Sovereign Observers rarely trade CDS directly, but may track
spreads as a market-implied signal of creditworthiness or counterparty risk. Their
engagement is typically indirect—via treasury teams, IR desks, or macro risk
monitors.

CDS markets may seem technical and peripheral during calm periods, but they
move to the centre of the action in moments of stress.

Credit default swaps function as early-warning signals and systemic risk

transmission channels. When spreads widen aggressively, it o�en re�ects
deteriorating credit conditions. But the feedback loop is circular: the rising cost of
protection can amplify fear, restrict funding access, and force position unwinds,
exacerbating the very risk it was meant to hedge.

Historical examples:

Global Financial Crisis (2007–2008)

CDS spreads on Bear Stearns and Lehman Brothers widened long before equity
markets collapsed. They were some of the earliest public indicators of acute
balance sheet fragility.

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Eurozone crisis (2011–2012)

Sovereign CDS spreads on Greece, Portugal, and Italy signalled restructuring risk
months before formal EU acknowledgement.

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Global Pandemic (March 2020)

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During the early COVID panic, index CDS (on both IG and HY) gapped wider in
illiquid conditions, re�ecting growing concern over mass downgrades and
corporate solvency.

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Default Chains and Counterparty Risk:

In theory, a CDS seller pays out when a credit event occurs. But in large-scale
defaults, especially sovereign or clustered HY names, the bigger question
becomes, “Can they?”

This was a central issue during the 2008 crisis. AIG’s collapse wasn’t just about
housing; it was about the $440bn of CDS protection they’d sold, much of it
unhedged and under-collateralised. When margin calls began, AIG couldn’t meet
them, triggering a systemic panic. A $180bn government rescue followed, not just
to save AIG but to prevent its counterparties from collapsing, too.

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CDS isn’t just about credit—it’s also about who stands behind the trade.

CDS markets may appear niche, but are critical to how risk is priced, transferred,
and hedged in modern credit markets. Their role goes beyond insurance. They
in�uence how credit spreads behave, how bonds are valued, and how liquidity is
distributed in stressed conditions.

Risk Transfer Mechanism:

At their core, CDS contracts separate credit risk from bond ownership. This
allows investors to hedge or express views without trading the underlying cash
instruments. A portfolio manager can hedge default risk on a high-yield bond
book without touching the bonds themselves. Conversely, a trader can go long
CDS to express a bearish credit view even if they don’t hold the bonds.

This ability to unbundle risk supports market e�ciency and enhances �exibility
in managing exposure across books and institutions.

CDS also allows for more nimble expression of views across capital structures. For
example, an investor may prefer to hedge credit risk via CDS rather than reduce

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bond exposure, especially when the bonds are illiquid or tightly held. In some
situations, the CDS may represent the only tradable instrument pricing in default
risk with real-time transparency.

Price Discovery and Signalling:

CDS spreads are o�en seen as a purer signal of credit risk than cash bonds. CDS
contracts are standardised, centrally cleared (in many cases), and trade with
tighter bid-ask spreads, especially in the index space. In volatile markets or
around idiosyncratic events (e.g., earnings, downgrades, or restructuring rumours),
CDS prices o�en move faster than bond spreads, providing a leading indicator of
credit stress.

This dynamic makes CDS useful not just for risk management, but also for credit
surveillance. Traders, portfolio managers, and even corporate treasurers o�en
monitor CDS levels as early warning indicators for counterparty or sector risk.

For this reason, CDS is a critical input in cross-asset pricing models, counterparty
risk frameworks, and synthetic credit instruments.

Credit-Bond Basis and Market Arbitrage:

The relationship between CDS spreads and bond spreads, the credit-bond basis, is

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one of the most widely watched dislocations in credit markets. Arbitrageurs track
this closely, stepping in when the two markets diverge. This dynamic enforces
pricing discipline and links derivatives to physical credit markets. A negative
basis, for instance, can o�er hedge funds a way to earn carry while being hedged
for credit risk.

In liquid names, this arbitrage helps tether CDS and bond markets together. In
stressed scenarios, a breakdown in this basis can signal fractured liquidity or
impaired market functioning.

These basis trades are also closely watched by macro funds, who use them to
express broader views on market dislocation, central bank credibility, or systemic
stress. The magnitude and persistence of basis gaps can reveal where market
plumbing is starting to strain.

Liquidity Backstop in Stress:

During periods of bond market dysfunction, especially in lower-rated or high-

yield names, CDS o�en remains more liquid than cash bonds. Investors who
struggle to o�oad bonds during a sell-o� may hedge using CDS instead, or trade
index CDS as a proxy for exposure. This “�ight to derivatives” supports price
discovery when underlying bonds are bidless or subject to wide pricing
dispersion.

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In that sense, CDS markets o�en act as a last-resort liquidity window. When bond
markets lock up, CDS can still print—a critical feature for anyone needing to
o�oad risk in real time.

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Credit default swaps remain among global �nance’s most important yet
misunderstood corners. To some, they’re just insurance. But in practice, they sit at
the heart of how credit risk is transferred, priced, and managed across portfolios
and market participants.

Used correctly, CDS contracts o�er precision tools for hedging and speculation.
They allow investors to separate credit risk from duration, express relative value
views, or protect portfolios against systemic events. They also provide critical
price signals, helping market participants navigate credit cycles and manage risk
through volatility.

They’ve become a vital part of modern market architecture, not just for trading
credit but also for managing capital, aligning with regulatory regimes, and
structuring balance sheet exposures across institutions.

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Whether running a macro book, managing an IG bond fund, or watching

counterparty risk at a bank, CDS markets sit close to the core of how credit is
expressed and defended.

From bank balance sheets to high-yield ETFs, from structured credit desks to
pension funds, CDS markets touch far more of the �nancial ecosystem than most
realise.

We hope you enjoyed this primer and insights on credit default swaps. Please
leave a like to show your support. As always, comments and opinions are welcome.

AP

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Global Primer Series: Credit Default Swaps - AlphaPicks https://www.alphapicks.co.uk/p/global-primer-series-credit-default

1 Credit event: A de�ned trigger in a CDS contract (such as failure to pay, bankruptcy, or
restructuring) that obligates the CDS seller to compensate the buyer.

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Jesse Williamson 1h

“Any way to do 200 million?”

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D K 1h

thank you
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