CFA Level II Exam · Credit Default Swaps

CDS Credit Events and Settlement Protocols Explained

Updated 7 October 2026 · Fact-checked

A credit default swap pays the protection buyer only when a credit event occurs, such as bankruptcy, failure to pay or restructuring. After the event, the contract settles by physical delivery of the defaulted bond or, more commonly, by cash settlement based on an auction price. Payout = notional × (1 − recovery rate).

Understand Credit Events and Settlement Protocols

A credit default swap (CDS) is insurance-like protection on a reference entity's debt. The protection buyer pays a periodic premium. The protection seller pays out only if a credit event happens. So the first question in any exam item is: did a defined credit event occur?

The three main credit events are:
- Bankruptcy: the reference entity becomes insolvent or is unable to pay its debts, or enters a legal process such as liquidation or similar protection from creditors.
- Failure to pay: the entity misses a payment due on its debt after any grace period has passed, above a minimum amount set in the contract.
- Restructuring: the entity changes debt terms in a way that hurts creditors and is forced by distress. Examples are lower coupon, lower principal, a delayed payment date or a change in ranking. A voluntary, market-driven change does not count.

Not every CDS includes restructuring. In the CFA curriculum, the point is that restructuring is the contested event, because it is a softer event than default. Sellers worry that buyers could claim payout on a mild restructuring while holding the cheapest bond to deliver. Contracts therefore differ on whether restructuring is covered and how broadly. Where covered, limits on which bonds can be delivered reduce the abuse. Do not assume every contract treats restructuring the same way. Read what the vignette says.

Who decides that an event happened? In the standardised market, an industry body, the ISDA Credit Derivatives Determinations Committee, decides whether a credit event has occurred and runs related decisions, such as the auction. This gives one consistent answer for all contracts on the same entity.

After the event, the CDS settles in one of two ways. In physical settlement, the buyer delivers the defaulted bond at face value and receives the notional amount in cash. In cash settlement, the seller pays the buyer the loss: notional × (1 − recovery rate). The recovery rate comes from the market price of the defaulted debt, usually found in a credit event auction. The auction sets a single final price for the cheapest-to-deliver type of bond, so all participants settle on the same number. Cash settlement via auction is the norm today because it avoids the buyer needing to own the bond and avoids a squeeze in the bond market.

The cheapest-to-deliver idea matters. If several bonds of the reference entity rank equally, they may trade at similar prices after default. If prices differ, the buyer under physical settlement delivers the one that is cheapest, because they receive face value either way. The auction aims to find the price of that bond.

Key formulas to remember

Cash settlement payout: Payout = Notional × (1 − Recovery rate); Recovery rate is the auction final price as a percent of par. Equivalent form: Notional × (Par − Auction price) ÷ Par.
Payout using loss given default: Payout = Notional × LGD, where LGD = 1 − Recovery rate; Loss given default is the same figure as the payout percentage.
Physical settlement net result for buyer: Net = Notional (cash received) − Market value of delivered bond (at purchase); Buyer delivers bonds with face value equal to notional and receives par in cash. Economic gain relative to market value of the bond is Notional × (1 − recovery rate).
Credit events (rule list): Bankruptcy, Failure to pay, Restructuring; Restructuring must be a forced change in terms due to deteriorating credit. Not always covered in the contract.

How to solve Credit Events and Settlement Protocols questions

Use the same sequence for every credit event or settlement question in a vignette.

1Identify the reference entity and the contract: who is the protection buyer and who is the seller, and what is the notional?
2Test the event against the three definitions. Check grace periods, minimum amounts and whether a restructuring was forced by distress or voluntary.
3Check whether the contract covers restructuring and whether the committee has ruled the event a credit event.
4Find the settlement type stated: physical or cash. If not stated, assume the standard auction-based cash settlement.
5For cash settlement, find the recovery rate or auction price. Compute Notional × (1 − Recovery rate).
6For physical settlement, the buyer delivers bonds with face value equal to notional and receives the notional in cash. Compare with the bond's market value if asked about the gain.
7Account for accrued premium if the vignette says the buyer owes it up to the event date, and check the answer is in the right currency and units.

Quickest way: Three-check shortcut

When to use it: Use when the vignette is long and the question just asks whether a payout occurs or how much.

Check one: did a defined credit event happen, forced and not voluntary, and is it covered by the contract?
Check two: find the auction price or recovery rate in the exhibit. Payout percent = 100% minus that price.
Check three: multiply by notional. For physical settlement, the buyer receives par for the delivered bond, so the buyer's loss is covered in full.

Common mistakes in Credit Events and Settlement Protocols

Treating any missed payment as a credit event immediately.
Students forget grace periods and materiality thresholds.
Fix: Check whether the grace period has passed and the missed amount exceeds the minimum in the contract.
Calling a voluntary debt exchange a restructuring credit event.
The word restructuring sounds like it always counts.
Fix: A restructuring credit event requires terms worsened for creditors because of credit deterioration. Voluntary or market-driven changes do not trigger payout.
Using the auction price as the payout percentage.
Students confuse the price of the defaulted bond with the loss.
Fix: The auction price is the recovery rate. The payout is 1 minus it, times notional.
Assuming physical settlement pays only the loss.
Mixing up the two settlement methods.
Fix: In physical settlement the buyer hands over the bond and gets full notional. In cash settlement the seller pays only notional × (1 − recovery).
Assuming the individual counterparties decide whether a credit event happened.
Students overlook the role of the committee.
Fix: In standardised CDS the ISDA Determinations Committee decides, and its ruling applies across contracts on the entity.
Assuming all CDS cover restructuring.
Restructuring is listed with the other two events, so it appears automatic.
Fix: Check the vignette. Contracts can exclude it or limit deliverable bonds, which changes the outcome.

Worked examples

Example 1

Vignette: A fund bought ₹50,00,00,000 notional of five-year CDS protection on Orion Corp. Orion missed a coupon, and after the grace period passed, the Determinations Committee ruled a failure-to-pay credit event. The contract is cash settled. The auction final price was 35% of par. Q1: Is there a credit event? Q2: What is the cash settlement payment? Q3: Who pays it?

Show the solution

Q1: Orion missed a payment and the grace period expired. The committee confirmed it, so a failure-to-pay credit event occurred.
Q2: Recovery rate = 35%. Payout percentage = 1 − 0.35 = 0.65.
Payout = ₹50,00,00,000 × 0.65 = ₹32,50,00,000.
Q3: The protection seller pays the protection buyer.

Answer: Yes, a failure-to-pay event occurred. The seller pays the fund ₹32,50,00,000.

Example 2

Vignette: Bank A bought protection on €20 million notional of Delta SA debt. Delta offered bondholders a voluntary exchange into new bonds with a longer maturity, and it was not in distress. Later Delta entered bankruptcy and the bonds trade at 40% of par. The contract is physically settled. Q1: Did the voluntary exchange trigger the CDS? Q2: What does Bank A receive on physical settlement if it delivers bonds with €20 million face value? Q3: What is its net economic gain compared with the bond's market value?

Show the solution

Q1: A restructuring event needs a forced change in terms because of credit deterioration. The exchange was voluntary and Delta was not in distress, so it did not trigger the CDS.
Q2: The later bankruptcy is a credit event. Under physical settlement Bank A delivers bonds with face value €20 million and receives €20 million in cash.
Q3: The delivered bonds are worth 0.40 × €20 million = €8 million in the market. Net gain relative to that value = €20 million − €8 million = €12 million. This equals €20 million × (1 − 0.40).

Answer: No, the voluntary exchange did not trigger it. Bank A receives €20 million in cash, giving a net gain of €12 million against the bonds' market value.

Exam tips

Read the vignette for the exact event wording: forced versus voluntary, grace period passed or not, and whether the committee ruled.
Write payout as notional × (1 − auction price) before looking at the options. Distractors often show the recovery amount instead.
If the vignette does not state the settlement type, think auction-based cash settlement, but only say so if the question allows it.
Questions on restructuring often test the difference between a hard event and a soft one. Link the answer to who benefits from delivering the cheapest bond.

Credit Events and Settlement Protocols: frequently asked questions

What are the main CDS credit events?

The main events are bankruptcy, failure to pay and restructuring. Failure to pay applies after any grace period and above a minimum amount. Restructuring must be a forced change in debt terms due to credit deterioration, and not every contract covers it.

What is the difference between physical and cash settlement of a CDS?

In physical settlement the buyer delivers the defaulted bond and receives the notional in cash. In cash settlement the seller pays notional × (1 − recovery rate), with the recovery rate taken from the market, usually an auction. Cash settlement is the standard approach in the standardised market.

How does a CDS auction work?

After a credit event, an auction sets a single final price for the defaulted debt, reflecting the cheapest-to-deliver bond. That price is the recovery rate for cash settlement. Using one price means all contracts on the entity settle consistently.

What does the ISDA Determinations Committee do?

It is an industry committee that decides whether a credit event has occurred for a reference entity and organises related steps such as the auction. Its decision applies to standardised contracts on that entity, so counterparties do not need to argue it bilaterally.