Credit Default Swaps Explained: Spreads and Protection
A credit default swap (CDS) is a credit derivative in which a protection buyer pays a premium in exchange for a specified payment following a qualifying credit event under the contract. CDS spreads can reflect market compensation for credit risk, liquidity and other factors. They do not directly equal the probability that a company will default.
CDS protection buyer and seller
The buyer of protection makes contractual premium payments, often expressed as a basis-point rate on a notional amount. The seller agrees to make a settlement payment if a defined credit event occurs, subject to the documentation and settlement mechanism. The derivative may reference a single company or a basket/index. Buying protection can hedge an existing credit exposure, but it can also represent a speculative view without owning the underlying bond.
Worked example: annual premium
Suppose a fictional CDS has $10 million notional and an annual running spread of 150 basis points, or 1.50%. An illustrative annual premium is $10m × 0.015 = $150,000 before payment frequency, upfront amounts and accrual adjustments. Actual standard CDS contracts can trade with fixed coupon conventions plus an upfront payment. The quoted market spread therefore should not be assumed to equal the cash coupon under every contract.
What counts as a credit event
Standardised documentation defines events such as bankruptcy, failure to pay and certain restructurings, with distinctions by market and contract. A bad earnings report, credit-rating downgrade or sharp share-price fall is not automatically a CDS credit event. Eligibility of debt obligations, timing and the decision process matter. The relevant determination committee and settlement auction rules can influence whether and how protection is paid.
Illustrative settlement after a credit event
Assume a $10m notional exposure and a hypothetical recovery value of 40% under a simplified cash-settlement rule. The protection payment would be roughly (1 − 0.40) × $10m = $6m. This is not a universal contractual result: recovery is determined by eligible obligations and settlement arrangements, and counterparties may have to make final accrued premium payments. A CDS hedge can also differ from losses on the particular bond held.
Why CDS spreads change before default
Investors may revise expected loss because of changes in the borrower’s leverage, operating outlook, funding access and macroeconomic conditions. Liquidity, dealer balance sheets, contract maturity and technical positioning also affect quotes. A widening spread generally indicates that compensation for protection is increasing, but attributing every basis-point change to default probability is incorrect.
CDS spreads versus bond credit spreads
A corporate bond’s yield spread includes credit compensation along with liquidity, tax, option and other effects. CDS contracts have their own funding, collateral and market-technical considerations. CDS-bond basis can arise when those markets price related exposure differently. Arbitrage in theory can be constrained by borrowing, transaction costs, settlement, counterparty and balance-sheet limits.
Credit hedging and residual basis risk
A bank holding a specific five-year bond may buy CDS protection with a matching reference entity and notional. Yet the bond’s exact seniority, maturity and deliverability may not line up perfectly with the swap. A hedge can reduce part of expected credit loss while exposing the bank to a separate basis or liquidity risk. A perfect-looking notional match is not always an exact economic hedge.
Interpretation checklist
Identify reference entity, seniority, notional, maturity, spread convention, upfront payment, standard documentation and deliverable obligations. Compare CDS changes with financial results and debt maturities, and distinguish a market quote from a statistical model probability. Do not treat the CDS spread as a guarantee of either default or survival.
Credit default swap premiums: a simplified worksheet
The following original example uses hypothetical inputs to illustrate the method; it is not an actual market quotation.
| Spread | Notional protection | Approximate annual premium |
|---|---|---|
| 150 basis points | £10 million | £150,000 |
| 200 basis points | £10 million | £200,000 |
| 300 basis points | £10 million | £300,000 |
| 200 bp with four equal quarters | £10 million | ≈ £50,000 each quarter before accrual adjustments |
One hundred basis points equals one percentage point of annual notional. This table ignores conventions such as standardised running coupons, upfront payments, accrual, recovery assumptions and discounting, so it is not a dealer quotation or a fair-value model. A wider quoted CDS spread may reflect a higher perceived probability of default, changes in assumed recovery, market liquidity, restructuring terms or counterparty considerations. Buying protection does not remove every basis, settlement or contractual risk.
Frequently asked questions
Does a 500-basis-point CDS spread mean 5% default probability?
No. Converting spread to an implied probability requires recovery, discounting and other assumptions.
Can CDS be bought without owning a bond?
In many markets yes, subject to applicable rules and trading access.
Is a downgrade a CDS credit event?
Not automatically; qualifying events are defined in the contract.
Sources and further reading
Continue learning with Bond Valuation Fundamentals in the Traders MBA Education library.