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CFA Level II · CFA Level II Exam

Credit Default Swaps for CFA Level II

A credit default swap (CDS) is a derivative where the protection buyer pays a periodic premium and receives a payout if a credit event hits the reference entity. To solve CDS questions, find the spread, coupon, duration and recovery rate in the vignette, then apply the pricing and valuation formulas.

What this chapter covers

This chapter covers credit default swaps, the main tool for transferring credit risk. You learn who the parties are, what counts as a credit event, how the contract settles, and how the standard coupon and upfront payment work. You then price a CDS from spreads and hazard rates, and value it after inception when spreads move.

The chapter sits in the Fixed Income topic, next to credit analysis and credit risk models. Ideas like probability of default, loss given default, recovery rate and expected loss carry straight over. Spread duration and the link between yield spreads and price changes are also reused.

It also connects to Derivatives and Risk Management and to Portfolio Construction. CDS are used to hedge bond exposure, adjust portfolio credit risk, and build basis trades. Expect a vignette that gives market quotes and asks you to compute a price or a value, then judge a strategy.

CDS questions mix concepts with short calculations, and both sit inside Fixed Income item sets, which carry a large share of the paper. Most calculations use a few repeated formulas, so the marks are reachable once you practise. The same credit ideas also help you in other credit questions, so time spent here pays back across the exam.

Credit Default Swaps: topics in the order to study them

  1. 1CDS Basics and Market StructureYou need the vocabulary first: protection buyer and seller, reference entity, reference obligation, index and single-name CDS.
  2. 2Credit Events and Settlement ProtocolsOnce you know the contract, learn what triggers a payout and how it is settled, by auction or physical delivery.
  3. 3CDS Pricing: Spreads, Upfront Premium and Hazard RatePricing builds on the standard coupon and on default probability and recovery, so it comes after the contract mechanics.
  4. 4CDS Valuation and Changes After InceptionValuation reuses the pricing inputs and asks how value changes as the market spread moves from the contract spread.
  5. 5Applications of CDS and Basis TradesApplications and basis trades need everything before them, so study them last and use them to test your understanding.

How to prepare Credit Default Swaps

Build the concepts first, then drill the calculations until the steps are automatic. Keep a one-page sheet of formulas and rules.

  1. Read the contract mechanics and write a short note on each party, who pays what, and when.
  2. Learn the credit events and the settlement methods, and be able to say which events apply in which situation.
  3. Practise the pricing relationships: approximate upfront premium from the spread difference times duration, and the link between spread, probability of default and loss given default.
  4. Work valuation problems in a fixed order: find the change in spread (market spread minus contract spread), then compute change in CDS value ≈ change in spread × effective spread duration × notional, then decide who gains. The protection buyer gains when spreads widen.
  5. Do at least two full vignettes that mix calculation with a strategy question on hedging or basis trades.
  6. Review each wrong answer and note whether the error was a concept, a sign, or a data-reading slip.
  7. On the last days, reread your formula sheet and redo only the problems you missed.

Common mistakes in Credit Default Swaps

  • Mixing up who gains when spreads widen.

    Fix: Remember that protection buyers gain when spreads widen, because the contract they hold is now worth more. Size the gain as change in spread × effective spread duration × notional.

  • Using the wrong spread in the upfront premium formula.

    Fix: Label each number as CDS spread, standard coupon or bond spread before calculating, and subtract coupon from spread.

  • Forgetting recovery rate when computing loss.

    Fix: Write loss given default = 1 − recovery rate every time and apply it before finishing.

  • Confusing the CDS spread with the coupon.

    Fix: Treat the coupon as what is actually paid and the spread as the market price of risk; the upfront payment bridges the gap. The protection buyer pays it when spread > coupon and receives it when spread < coupon.

  • Misreading the sign of the basis and its trade.

    Fix: Compute the basis as CDS spread minus bond spread. If it is negative, the bond looks cheap relative to CDS, so buy the bond and buy CDS protection. If it is positive, the bond looks expensive relative to CDS, so sell or short the bond and sell CDS protection. Note that shorting the bond can be hard to do in practice.

  • Ignoring data in the vignette about credit events or restructuring.

    Fix: Reread the vignette for the event described and match it to the defined credit events before answering.

Last-day revision: Credit Default Swaps

  • The protection buyer pays the premium; the seller pays if a credit event occurs.
  • The reference entity is the issuer whose credit risk is covered.
  • Credit events include bankruptcy, failure to pay and, in some contracts, restructuring.
  • Settlement can be by auction (cash) or physical delivery of the bond.
  • Approximate payout is notional × (1 − recovery rate).
  • Approximate credit spread ≈ annual probability of default (hazard rate) × loss given default.
  • Approximate upfront premium (% of notional) ≈ (CDS spread − CDS coupon) × effective spread duration. Multiply by notional for the amount. The protection buyer pays the upfront premium when the CDS spread is above the coupon and receives it when the spread is below the coupon. CDS price ≈ 100 − upfront premium %.
  • Change in CDS value ≈ change in spread × effective spread duration × notional. If the market spread rises above the contract spread, the protection buyer gains.
  • If the market spread falls, the protection seller gains.
  • A rising hazard rate means a higher default probability and a higher spread.
  • Basis = CDS spread − bond credit spread. A negative basis (CDS spread < bond spread) means the bond looks cheap relative to CDS, so buy the bond and buy CDS protection. A positive basis (CDS spread > bond spread) means the bond looks expensive relative to CDS, so sell or short the bond and sell CDS protection. Shorting the bond can be hard to implement in practice.
  • Buying protection on a bond you hold reduces credit risk but leaves other risks.

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 Default Swaps: frequently asked questions

How much calculation is in the CDS chapter?

There are a few short calculations, mainly the upfront premium, the change in value after a spread move, and expected loss. They use a small set of formulas. Conceptual questions on events, settlement and basis trades appear alongside them.

Which topic should I learn first?

Start with CDS basics and market structure. Everything else depends on knowing the parties, the reference entity and how premiums and payouts flow.

Do I need to memorise formulas for CDS?

Yes, but there are only a few, and each has a clear logic. Learn why each works, such as spread difference times duration, so you can rebuild it if you forget.

How does this chapter link to other Level II topics?

It builds on credit analysis in Fixed Income and reuses ideas like default probability and recovery. It also links to derivatives and to portfolio risk management through hedging.