CFA Level I Exam · Forward Commitment and Contingent Claim Features and Instruments

Credit Default Swaps Explained for CFA Level I

Updated 7 October 2026 · Fact-checked

A credit default swap (CDS) is a contingent claim on a credit event. The protection buyer pays a periodic premium. The protection seller pays compensation if a credit event such as bankruptcy or failure to pay occurs on the reference entity. To solve questions, identify who pays, who receives, and what triggers settlement.

Understand Credit Derivatives and Credit Default Swaps

A credit derivative is a contract whose value depends on the credit quality of a borrower. The most common one is the credit default swap (CDS). It works like insurance against default on a bond or loan, although it is a derivative, not an insurance policy.

There are two parties. The protection buyer pays a regular fee, called the CDS spread or premium. The protection seller receives that fee and promises to pay if a credit event happens. The reference entity is the borrower whose credit risk is covered. The reference obligation is the specific debt instrument used to define the contract, usually a senior unsecured bond.

A CDS is a contingent claim, because the seller's payout depends on whether a credit event occurs. The buyer's premium payments are certain while the contract lives. Typical credit events are bankruptcy and failure to pay. Restructuring is a credit event in some contracts only, depending on the documentation. Exact terms are set in the contract documentation.

If a credit event occurs, the contract settles. Under physical settlement, the buyer delivers the defaulted bond to the seller and receives the notional (face) amount. Under cash settlement, the seller pays the buyer the loss, which is notional × (1 − recovery rate). The recovery rate is usually set by an auction or by the market price of the cheapest defaulted bond. After the credit event, premium payments stop.

The buyer gains when credit quality of the reference entity falls, because the spread on new CDS rises and the existing contract becomes more valuable. The change in the market value of a CDS depends on the change in spread and on the CDS's risky duration, which is the sensitivity of the PV of its premium annuity. The seller gains when credit quality improves, which is like holding a long position in the credit risk. A CDS index covers a basket of reference entities. A single-name CDS covers one entity.

Key formulas to remember

Cash settlement payout: Payout = Notional × (1 − Recovery rate); Equivalently Notional × loss given default. Paid by seller to buyer after a credit event.
Loss given default: LGD = 1 − Recovery rate; Recovery rate is the fraction of face value recovered.
Annual CDS premium: Premium = CDS spread × Notional; Paid by the protection buyer, usually quarterly. Divide by the number of payments per year for each payment.
Approximate change in CDS market value: ΔValue ≈ ΔSpread × Risky duration × Notional; Approximation. Risky duration is the CDS's own duration, the sensitivity of the PV of its premium annuity (not a bond's duration). Value rises for the buyer when the spread widens, and falls for the seller.
Approximate CDS spread: Spread ≈ Probability of default × LGD; Rough annual relationship used for intuition, not an exact pricing formula.

How to solve Credit Derivatives and Credit Default Swaps questions

Use this sequence for any CDS question.

1Identify the roles: who is the protection buyer (pays premium) and who is the seller (pays on a credit event).
2Identify the reference entity and notional amount.
3Check whether a credit event occurred. If not, only premiums are paid and no payout is due.
4If a credit event occurred, see whether the question uses physical or cash settlement.
5For cash settlement, compute Notional × (1 − Recovery rate). For physical settlement, the buyer receives full notional against delivering the bond.
6For premium questions, compute spread × notional and adjust for payment frequency.
7For value questions, link spread widening to gain for the buyer and loss for the seller. The size of the change is approximately ΔSpread × risky duration × notional, where risky duration is the CDS's own duration.
8Check the answer is positive and sensible, then choose the option that matches.

Quickest way: Buyer pays, seller covers loss

When to use it: Use for most standalone three-option questions on CDS roles, settlement and value changes.

Remember: buyer = short credit risk, seller = long credit risk.
Spread widens: buyer gains, seller loses. Spread tightens: the opposite.
Cash payout = notional × (1 − recovery). Compute it first and eliminate options that use the recovery rate directly.
No credit event means no payout, regardless of price moves in the bond.
Eliminate the option that has the roles reversed.

Common mistakes in Credit Derivatives and Credit Default Swaps

Thinking the protection seller pays the premium.
The word 'protection' is confused with 'paying for protection'.
Fix: The buyer pays the premium and the seller receives it. The seller pays only after a credit event.
Using the recovery rate as the payout fraction.
Students see the recovery rate and multiply by it directly.
Fix: The seller pays the loss, so payout is notional × (1 − recovery rate).
Assuming a CDS pays whenever the bond price falls.
CDS is treated like a put option on price.
Fix: Payout needs a defined credit event. Price declines or downgrades alone do not trigger settlement.
Saying the buyer gains when credit quality improves.
Confusing the buyer's position with owning the bond.
Fix: The buyer benefits when credit risk rises, since protection is worth more. The seller benefits when it falls.
Continuing premium payments after a credit event.
Students forget the contract ends upon settlement.
Fix: Premiums stop at the credit event, with any accrued premium settled up to that date.

Worked examples

Example 1

An investor buys CDS protection on a €10,000,000 notional bond. The reference entity suffers a credit event and the recovery rate is set at 35%. Under cash settlement, what does the seller pay the buyer? The options are: A. €3,500,000, B. €6,500,000, C. €10,000,000.

Show the solution

Identify cash settlement: payout = notional × (1 − recovery rate).
Compute 1 − 0.35 = 0.65.
Multiply: €10,000,000 × 0.65 = €6,500,000.
Option A uses the recovery rate directly, which is a trap. Option C is the physical settlement amount against the bond delivery.

Answer: B. €6,500,000

Example 2

A fund buys CDS protection on a $20,000,000 notional with a spread of 1.80% a year, paid quarterly. What is each quarterly premium? The options are: A. $90,000, B. $180,000, C. $360,000.

Show the solution

Annual premium = 1.80% × $20,000,000 = $360,000.
Payments are quarterly, so divide by 4: $360,000 ÷ 4 = $90,000.
Option B is the semiannual amount, from dividing the annual premium by 2 instead of 4: $360,000 ÷ 2 = $180,000. Option C is the full annual premium.

Answer: A. $90,000

Exam tips

Draw the roles first: buyer pays premium, seller pays on credit event. Most role questions can be solved by that alone.
Watch the word 'recovery rate' in numerical items. The payout uses one minus it.
Note whether the question says physical or cash settlement before calculating.
Spread widening questions are about direction: it favours the protection buyer.
Options are listed smallest to largest, so check whether your answer falls at the expected position and test for the common trap values.

Practice questions from Forward Commitment and Contingent Claim Features and Instruments

Credit Derivatives and Credit Default Swaps in other exams

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

Credit Derivatives and Credit Default Swaps: frequently asked questions

What is a credit default swap in simple terms?

It is a contract where one party pays a regular premium and the other agrees to compensate it if a borrower suffers a credit event. It transfers credit risk from the buyer to the seller without selling the underlying bond.

What counts as a credit event for a CDS?

Common credit events are bankruptcy, failure to pay and, in some contracts, restructuring. The exact list is set in the contract documentation, so a price fall or rating downgrade alone does not normally trigger settlement.

What is the difference between physical and cash settlement?

In physical settlement, the buyer delivers the defaulted bond to the seller and receives the full notional. In cash settlement, the seller pays notional × (1 − recovery rate) and the buyer keeps the bond.

Who benefits when a CDS spread widens?

The protection buyer benefits, because the existing protection becomes more valuable as market credit risk rises. The protection seller suffers a mark-to-market loss.