Advanced Financial Management · Risk Management

Credit Risk and Credit Derivatives for CA Final AFM

Updated 5 October 2026 · Fact-checked

Credit risk is the chance that a borrower or counterparty fails to pay what it owes. You measure it as expected loss = PD × LGD × EAD. You manage it through rating, limits, collateral and credit derivatives such as a credit default swap, where the buyer pays a premium and receives compensation on a credit event.

Understand Credit Risk and Credit Derivatives

Credit risk is the risk of loss because a borrower does not pay interest or principal on time, or at all. It arises in loans, bonds, trade receivables and derivative contracts. The loss can also come from a fall in the borrower's credit quality, even without default, because the market value of its bonds falls.

Counterparty risk is a subset of credit risk. It is the risk that the other party to a contract, usually a derivative or forward, fails to perform when the contract has positive value to you. Credit risk is the wider term. It covers lending and bond holding as well. Counterparty risk matters when your exposure changes with market prices, such as in a swap.

Credit risk is measured with three inputs. Probability of default (PD) is the chance of default over a period. Loss given default (LGD) is the share of exposure you lose after recoveries, so LGD = 1 − recovery rate. Exposure at default (EAD) is the amount outstanding when default happens. Expected loss is the product of the three. Credit ratings from agencies give a quick view of PD. A lower rating means a higher PD and a higher yield demanded, called the credit spread.

You manage credit risk by screening borrowers, setting exposure limits, taking collateral or guarantees, diversifying, pricing for risk, and transferring risk. A credit default swap (CDS) is the main transfer tool. The protection buyer pays a periodic premium, called the CDS spread, on a notional amount. If a defined credit event occurs on the reference entity, the protection seller compensates the buyer for the loss. Settlement is either physical (buyer delivers the defaulted bond for par) or cash (seller pays par minus the recovery value).

Other credit derivatives include total return swaps, where one party passes on all the returns and price changes of a reference asset for a fixed or floating payment, and credit-linked notes, where the investor's repayment depends on the reference entity's credit. A CDS protects against loss from default but does not remove other risks, and the seller itself can default.

Key rules to remember

Expected loss: EL = PD × LGD × EAD; Use PD for the same period as the exposure. EL is a statistical average, not the worst case.
Loss given default: LGD = 1 − Recovery rate; Recovery rate is the share of exposure recovered after default.
Credit spread (approximate): Credit spread ≈ Yield on risky bond − Yield on risk-free bond; Compensation demanded for default risk. A rough approximation is spread ≈ PD × LGD.
Annual CDS premium: Premium = CDS spread × Notional; Spread is quoted in basis points. 100 bps = 1%.
CDS payout on credit event: Payout = Notional × (1 − Recovery rate); Applies to cash settlement. With physical settlement the seller pays par and receives the bond.
Net protection value for the buyer: Net gain = Payout − Premiums paid; Premiums stop at default. Count only premiums actually paid.
Probability of survival: Survival probability over n years = (1 − PD)ⁿ; Valid only if the same annual PD is assumed each year and years are independent.

How to solve Credit Risk and Credit Derivatives questions

Use this order for any credit risk or CDS question. It keeps numbers consistent and shows the examiner your logic.

1Identify what the question asks: expected loss, spread, CDS premium, payout, or a conceptual comparison.
2List the given data: exposure, PD, recovery rate or LGD, notional, CDS spread, time period.
3Convert units: basis points to percentage, and recovery rate to LGD where needed.
4Check that PD and exposure refer to the same period. If not, adjust.
5Apply the formula and show each step. For a CDS, separate the premium cash flows from the payout.
6For multi-year cases, track whether default happens in a given year. Premiums stop after default.
7Compute the net result for each party (buyer and seller) if asked.
8Add a one-line interpretation: what the figure means for the lender or the decision.

Quickest way: EL and CDS in four lines

When to use it: Use for MCQs and short numericals where PD, recovery and notional are given directly.

Write LGD = 1 − recovery first. Most slips happen here.
Compute EL = PD × LGD × EAD in rupees, not just percentage.
For a CDS, premium per year = spread in bps ÷ 10,000 × notional.
Payout on default = notional × LGD. Net for the buyer = payout − premiums paid up to default.

Common mistakes in Credit Risk and Credit Derivatives

Using the recovery rate as LGD in the expected loss formula.
Both are percentages and the question often gives only recovery.
Fix: Always write LGD = 1 − recovery before multiplying.
Treating credit risk and counterparty risk as the same thing.
Both involve a party failing to pay.
Fix: Say credit risk is the wider term covering loans and bonds. Counterparty risk is default by the other side of a contract, usually a derivative, where the exposure depends on market value.
Confusing the CDS spread with the credit spread on the bond.
Both measure default compensation and are often close in value.
Fix: The CDS spread is the annual premium for protection on the notional. The credit spread is the yield gap of a bond over the risk-free rate. They are related, not identical.
Continuing to count CDS premiums after the credit event.
Students apply the premium for the full contract term by habit.
Fix: Premiums stop on the credit event. Count only those paid up to default, including any accrued premium if the question says so.
Mixing basis points and percentages.
A spread of 150 bps is read as 150% or 1.5 as a fraction of 100.
Fix: Divide bps by 10,000. So 150 bps = 0.015 = 1.5%.
Saying a CDS removes all risk for the buyer.
The word protection suggests complete cover.
Fix: State that the buyer still bears the risk that the protection seller defaults, and that payout depends on a defined credit event.

Worked examples

Example 1

A bank has lent ₹50,00,000 to a manufacturing firm. The firm's one-year probability of default is 2%. If it defaults, the bank expects to recover 40% of the exposure. Compute the bank's expected loss for the year and explain what it means.

Show the solution

PD = 2% = 0.02.
Recovery rate = 40%, so LGD = 1 − 0.40 = 0.60.
EAD = ₹50,00,000.
EL = 0.02 × 0.60 × 50,00,000.
0.02 × 0.60 = 0.012.
0.012 × 50,00,000 = ₹60,000.

Answer: Expected loss = ₹60,000. This is the average annual loss the bank should expect on this loan. The bank should price it into the interest rate, for example about 1.2% of the exposure, over and above funding and operating costs.

Example 2

An investor holds bonds of Alpha Ltd with a face value of ₹2,00,00,000. To hedge, the investor buys a 5-year CDS on Alpha Ltd for the same notional at a spread of 150 bps per annum, paid annually at year-end. Alpha defaults during year 3, after the second premium has been paid, and the bonds are valued at 35% of par afterwards. Assuming cash settlement and no accrued premium, compute the premiums paid, the CDS payout, and the net CDS gain to the investor.

Show the solution

Annual premium = 150 ÷ 10,000 × 2,00,00,000 = 0.015 × 2,00,00,000 = ₹3,00,000.
Premiums paid before default: two payments, so 2 × 3,00,000 = ₹6,00,000.
Recovery rate = 35%, so LGD = 65%.
Payout = 2,00,00,000 × 0.65 = ₹1,30,00,000.
Net CDS gain = 1,30,00,000 − 6,00,000 = ₹1,24,00,000.
Check against the bond: value falls to 35% of 2,00,00,000 = ₹70,00,000, a loss of ₹1,30,00,000, which the payout offsets.

Answer: Premiums paid = ₹6,00,000. CDS payout = ₹1,30,00,000. Net CDS gain = ₹1,24,00,000. The payout exactly offsets the ₹1,30,00,000 fall in bond value, so the investor's net cost of protection is the ₹6,00,000 premium, ignoring the interest income lost and timing effects.

Exam tips

Show LGD = 1 − recovery as a separate line. Examiners look for it.
In CDS questions, split the answer into premium cash flows and the payout. Marks are given for each.
For theory, use the form: define, give the mechanism, then state one limitation, such as seller default or basis risk between the CDS and your actual holding.
Case-scenario MCQs often test the credit risk versus counterparty risk distinction and the settlement type. Read the settlement terms carefully.
Write units in rupees and state any assumption, such as annual payment or no accrued premium.

Practice questions from Risk Management

Credit Risk and Credit Derivatives in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Risk and Credit Derivatives: frequently asked questions

What is the difference between credit risk and counterparty risk?

Credit risk is the broad risk that a borrower or issuer fails to pay. Counterparty risk is the narrower case where the other party to a contract, such as a derivative, fails to perform. Counterparty exposure usually changes with market prices, while a loan exposure is mostly fixed.

How do I calculate expected loss in CA Final AFM?

Multiply probability of default, loss given default and exposure at default. Find LGD as 1 minus the recovery rate. Make sure PD covers the same period as the exposure.

How does a credit default swap work?

The protection buyer pays a regular premium on a notional amount to the protection seller. If a defined credit event happens on the reference entity, the seller compensates the buyer. Settlement can be physical, with delivery of the bond for par, or in cash for the loss amount.

Does a CDS remove all risk for the buyer?

No. The buyer still faces the risk that the seller cannot pay. There can also be a mismatch between the CDS terms and the asset held, so the hedge may not be perfect.