CFA Level II Exam · Credit Default Swaps

Credit Default Swap Basics and Market Structure

Updated 7 October 2026 · Fact-checked

A credit default swap (CDS) is a derivative that transfers credit risk. The protection buyer pays a periodic premium (the coupon). The protection seller pays compensation if a credit event hits the reference entity. To solve questions, identify who pays what, which obligation is covered, and whether the CDS is single-name or index.

Understand CDS Basics and Market Structure

A credit default swap is a contract that works like insurance on a bond's credit risk. One party, the protection buyer, pays a regular premium. The other party, the protection seller, promises to pay if a defined credit event happens, such as bankruptcy or failure to pay.

The company whose credit risk is being traded is the reference entity. The specific bond or loan used to define the claim and settle the payout is the reference obligation. The CDS covers the reference entity's credit risk, and often covers its senior unsecured debt of the same ranking, not only the one named bond. You do not need to own the bond to buy protection.

The contract has a notional principal, a maturity (commonly five years, with standard maturity dates in March, June, September and December), and a spread that is the market price of protection. Standard contracts use a fixed coupon (commonly 100 or 500 bps) paid on the notional. The buyer pays the coupon quarterly. If the market spread differs from the coupon, an upfront payment settles the difference. The buyer is short credit risk. The seller is long credit risk, like owning the bond. When credit quality worsens, spreads widen and the buyer gains.

A single-name CDS covers one reference entity. An index CDS covers a basket of entities, for example a standardized credit index with equal weights. If one name in an index defaults, that name is removed and the index notional shrinks. The buyer receives compensation only for that name's share of the notional, and the contract continues on the remaining names. Index CDS are more liquid and cheaper to trade than a set of single-name CDS, but the index spread may not equal the average of the component spreads because of liquidity and other differences.

CDS trade over the counter but are now typically centrally cleared, with standardized terms, which reduces counterparty risk. Credit events and settlement are covered in a separate topic. Here you need the structure: who pays, who is exposed, and what is covered.

Key formulas to remember

Protection buyer's periodic premium: Premium per period = Coupon × Notional × (days in period ÷ 360); Standard coupon is quoted annually. Quarterly payment is roughly coupon ÷ 4 of notional, though the day-count convention is actual/360. Check what the question tells you.
Index CDS notional after a default: Remaining notional = Original notional × (n − defaults) ÷ n; For an equally weighted index of n names. Each name carries notional ÷ n.
Payout on a credit event (single name): Payout = Notional × (1 − Recovery rate); Equals Notional × loss given default. Recovery rate is a fraction of par.
Direction of exposure: Buyer = short credit risk; Seller = long credit risk; Spread widening benefits the buyer and hurts the seller.

How to solve CDS Basics and Market Structure questions

Use this sequence on any item set question about CDS structure.

1Find the notional, the coupon, the reference entity, and whether the CDS is single-name or index in the vignette.
2Decide who is the protection buyer and who is the seller. Check the question for which party the investor is.
3Map the cash flows: buyer pays the coupon (and any upfront); seller pays only after a credit event.
4Apply the direction rule: buyer is short credit, seller is long credit. Link spread moves to gains and losses.
5For an index, find how many names defaulted and adjust the notional and payout by the equal share per name.
6For a payout, use Notional × (1 − recovery rate), using the share of notional affected.
7Check the answer against the vignette: units, annual versus quarterly, and which party receives the cash.

Quickest way: Buyer-seller direction check

When to use it: Use when the question asks who gains, who pays, or what risk a position has, without needing a full calculation.

Say it in one line: buyer pays coupon, seller pays on default.
Buyer is short credit risk and gains if spreads widen.
Seller is long credit risk and gains if spreads tighten or the coupon is earned without default.
For an index default, take notional ÷ n as the affected slice.
Payout is that slice × (1 − recovery).

Common mistakes in CDS Basics and Market Structure

Thinking the protection buyer must own the reference obligation.
The insurance analogy suggests you need to hold the asset.
Fix: A CDS can be bought purely to take a view on credit or hedge another exposure. Ownership is not required.
Saying the protection seller is short credit risk.
Students confuse selling a contract with shorting an asset.
Fix: The seller is exposed to the loss if default occurs, like holding the bond. The seller is long credit risk.
Treating the reference entity and the reference obligation as the same thing.
Both names sound alike.
Fix: The entity is the borrower whose credit is covered. The obligation is the specific debt used to define the claim and settlement.
Using the full index notional for the payout when one name defaults.
Students forget that an index CDS covers each name for an equal share.
Fix: Compute the payout on notional ÷ n only, then reduce the remaining notional.
Assuming the index spread is exactly the average of single-name spreads.
The index is a basket, so an average seems logical.
Fix: The index spread can differ from the average because of liquidity and other factors. Do not state equality as a rule.
Believing the seller pays the coupon.
Students mix up the flow of premium with the flow of compensation.
Fix: The buyer pays the coupon and any upfront. The seller pays only on a credit event.

Worked examples

Example 1

Vignette: Meridian Fund buys five-year protection on Corvane Industries with a notional of €20,000,000 through a standard single-name CDS. The fixed coupon is 1% a year. Corvane later suffers a credit event, and its reference obligation is valued at 40% of par after the event. Q1: Which risk position does Meridian hold? Q2: What annual coupon does Meridian pay? Q3: What is the payout to Meridian?

Show the solution

Q1: Meridian buys protection, so it is the protection buyer and is short credit risk on Corvane.
Q2: Annual coupon = 1% × €20,000,000 = €200,000. Paid quarterly, this is about €50,000 per quarter before day-count adjustments.
Q3: Recovery rate is 40%. Payout = €20,000,000 × (1 − 0.40) = €12,000,000.

Answer: Q1: Short credit risk. Q2: €200,000 a year. Q3: €12,000,000 paid by the protection seller.

Example 2

Vignette: Halden Capital sells protection on an equally weighted index of 25 reference entities with a notional of $50,000,000. One entity experiences a credit event, and its debt recovers 30% of par. Q1: What notional is attributed to the defaulted name? Q2: What does Halden pay? Q3: What notional remains in the index contract?

Show the solution

Q1: Each name carries $50,000,000 ÷ 25 = $2,000,000.
Q2: Payout = $2,000,000 × (1 − 0.30) = $1,400,000. Halden is the seller, so it pays this amount.
Q3: Remaining notional = $50,000,000 × 24 ÷ 25 = $48,000,000.

Answer: Q1: $2,000,000. Q2: Halden pays $1,400,000. Q3: $48,000,000 remains and the contract continues.

Exam tips

Always label buyer and seller first. Most wrong answers come from reversing the direction of risk.
In an index question, look for the number of names and defaults before doing any arithmetic.
If the vignette gives recovery as a percentage of par, convert it to a fraction and use 1 minus recovery.
Watch the wording on the reference obligation: the CDS covers the entity's credit risk, with the obligation used to define the claim.
Read which party the question asks about. The same event can gain for one side and cost the other.

CDS Basics and Market Structure in other exams

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

CDS Basics and Market Structure: frequently asked questions

Who pays whom in a credit default swap?

The protection buyer pays a periodic premium (the coupon) to the protection seller. The seller pays compensation to the buyer only if a credit event occurs on the reference entity. If no event occurs, the seller keeps the premiums.

What is the difference between a single-name CDS and an index CDS?

A single-name CDS covers one reference entity. An index CDS covers a basket of entities, usually equally weighted. If one name defaults in an index, only that name's share is paid out and the contract continues on the rest.

What is the difference between a reference entity and a reference obligation?

The reference entity is the borrower whose credit risk is covered. The reference obligation is the specific bond or loan used to define the claim and settle the contract. Coverage typically extends to debt of the same ranking.

Is the CDS protection buyer long or short credit risk?

The protection buyer is short credit risk. It gains when credit quality worsens and spreads widen. The protection seller is long credit risk and benefits when credit quality improves.