FRM Exam Part II · Credit Derivatives

Credit Default Swaps (CDS) Mechanics: Payments, Credit Events and Settlement

Updated 11 October 2026 · Fact-checked

A single-name CDS is insurance-like protection on a reference entity's credit. The buyer pays a periodic premium (the spread, or a fixed coupon plus upfront). If a credit event occurs, the seller pays the buyer par minus recovery, by cash or physical settlement. To solve questions, identify payer, amount and timing.

Understand Credit Default Swaps (CDS) Mechanics

A credit default swap (CDS) transfers the credit risk of a reference entity from the protection buyer to the protection seller. The buyer pays a regular premium on the notional. In return, the seller pays compensation if a credit event happens during the life of the contract.

The premium is quoted as a CDS spread in basis points per year. Payments are made quarterly in arrears, scaled by the day-count fraction. If a credit event occurs between payment dates, the buyer pays the accrued premium up to the event date, then payments stop.

Standard contracts trade with fixed coupons, commonly 100 bp or 500 bp per year. The market quotes a running spread, which is converted into an upfront payment so that the contract has zero value at the start. If the market spread is above the fixed coupon, the buyer pays upfront to the seller. If it is below, the seller pays upfront to the buyer. A rough approximation is upfront ≈ (spread − coupon) × risky annuity (duration of the premium leg).

Credit events are defined in the ISDA documentation. The usual ones are bankruptcy, failure to pay and restructuring. Others such as obligation acceleration, repudiation or moratorium can apply, mainly to sovereigns. Restructuring clauses (full, modified, modified-modified, or none) limit which obligations can be delivered after a restructuring. They matter because a restructuring can pay out without a true default, so the clause shapes the value of the protection.

Settlement is by physical delivery or by cash. In physical settlement, the buyer delivers defaulted bonds or loans with face value equal to the notional and receives par. The buyer will deliver the cheapest-to-deliver obligation. In cash settlement, the seller pays notional × (1 − recovery rate), where recovery is set by an auction of the defaulted debt. Both give the buyer the same economic payout if recovery is measured in the same way.

Key formulas to remember

Annual premium: Premium = CDS spread × notional; Quarterly payment ≈ spread × notional × day-count fraction, for example 0.25 for a quarter.
Protection payout: Payout = notional × (1 − recovery rate); Same for cash settlement (auction recovery) and physical settlement (par minus market value of delivered bond).
Upfront payment (approximation): Upfront ≈ (market spread − fixed coupon) × risky annuity × notional; Positive means the buyer pays the seller. Risky annuity is the PV of 1 per year paid while the entity survives.
Credit triangle (approximation): Spread ≈ PD (hazard rate) × (1 − recovery rate); A rule of thumb with constant hazard rate. Gives annual risk-neutral default intensity from a spread.
Accrued premium on default: Accrual = spread × notional × (days since last payment ÷ day-count basis); Paid by the buyer at the credit event.

How to solve Credit Default Swaps (CDS) Mechanics questions

Use this order for any CDS mechanics question. It keeps the cash flow directions and amounts straight.

1Identify the reference entity, notional, tenor, and who is buyer and seller.
2Write down the spread or coupon in decimals (100 bp = 1%) and the payment frequency.
3Compute the regular premium: notional × spread × day-count fraction.
4If the question gives a standard coupon and a market spread, decide the upfront direction: market spread above coupon means the buyer pays upfront.
5Check whether a credit event occurred and whether it is covered by the contract, including any restructuring clause.
6If it did, compute the accrued premium due and the protection payment notional × (1 − recovery).
7For settlement, state cash (auction recovery) or physical (deliver bonds at par), and note cheapest-to-deliver for physical.
8Check signs and interpret: who pays whom, and the net position of each party.

Quickest way: Direction and size check

When to use it: For multiple-choice questions on premiums, payouts and upfront direction when you have little time.

Premium = spread × notional × fraction of the year. Buyer pays it.
Payout = notional × (1 − recovery). Seller pays it.
Upfront sign: market spread minus coupon. Positive, buyer pays.
Credit triangle for quick checks: spread ÷ (1 − recovery) ≈ default intensity.
Eliminate options with wrong direction or that use recovery instead of loss given default.

Common mistakes in Credit Default Swaps (CDS) Mechanics

Using the recovery rate as the payout instead of 1 − recovery.
Both numbers appear in the question and recovery is the one stated.
Fix: Payout is the loss: notional × (1 − recovery). Recovery is what the buyer keeps through the bond's value.
Getting the upfront direction wrong.
Students forget the fixed coupon is below or above market.
Fix: Compare market spread with the fixed coupon. Higher market spread means the buyer must compensate the seller upfront.
Ignoring accrued premium at default.
The payout is the focus and the last partial period is forgotten.
Fix: Add the accrued premium the buyer owes up to the event date, then stop premium payments.
Treating restructuring as always a credit event.
Students assume all standard events apply in every contract.
Fix: Check the restructuring clause. Modified and modified-modified clauses restrict deliverable obligations, and some contracts exclude restructuring altogether.
Saying physical and cash settlement give different economics.
The mechanics look different.
Fix: Both pay par minus recovery value. Differences come from delivery option (cheapest-to-deliver) and auction versus actual recovery.
Mixing basis points and percentages.
Spreads are quoted in bp.
Fix: Convert first: 250 bp = 0.025. Then multiply by notional.

Worked examples

Example 1

A bank buys 5-year protection on USD 20 million notional of a corporate at a spread of 180 bp, paid quarterly (day-count fraction 0.25). After 2 years and 1 month... more simply: a credit event occurs exactly at a payment date with an auction recovery of 35%. Compute the quarterly premium and the cash settlement payout.

Show the solution

Quarterly premium = 20,000,000 × 0.018 × 0.25 = 90,000.
No accrual is owed because the event is on a payment date.
Payout = 20,000,000 × (1 − 0.35) = 20,000,000 × 0.65 = 13,000,000.

Answer: Quarterly premium is USD 90,000 paid by the buyer. The seller pays USD 13,000,000 in cash settlement.

Example 2

A 5-year CDS on a reference entity trades with a standard fixed coupon of 100 bp. The market spread is 300 bp and the risky annuity is 4.2. For notional EUR 10 million, estimate the upfront payment and say who pays.

Show the solution

Spread difference = 300 − 100 = 200 bp = 0.02.
Upfront ≈ 0.02 × 4.2 × 10,000,000 = 840,000.
Market spread exceeds the coupon, so the buyer is paying less running premium than the risk warrants.
The buyer therefore compensates the seller upfront.

Answer: The protection buyer pays about EUR 840,000 upfront to the seller.

Exam tips

Always settle direction first: buyer pays premium and upfront (if market spread above coupon), seller pays on default.
Expect questions linking spread to default probability through the credit triangle. Use it only as an approximation and say so.
Know the restructuring clause names and what each restricts. Questions often ask which clause favours the buyer or seller.
For settlement questions, remember the auction sets cash recovery and the buyer picks cheapest-to-deliver in physical settlement.
Watch units: bp, annual versus quarterly, and notional currency.

Practice questions from Credit Derivatives

Credit Default Swaps (CDS) Mechanics 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 (CDS) Mechanics: frequently asked questions

What does the protection buyer pay and receive in a CDS?

The buyer pays a periodic premium based on the spread, plus any upfront amount. If a credit event occurs, the buyer receives notional × (1 − recovery) and pays accrued premium to the event date.

Why is there an upfront payment in a CDS?

Standard contracts have fixed coupons such as 100 or 500 bp. The market spread rarely equals the coupon, so an upfront payment makes the contract worth zero at the start. It is roughly the spread difference times the risky annuity.

What is the difference between cash and physical settlement?

In physical settlement, the buyer delivers defaulted debt with face value equal to the notional and receives par. In cash settlement, the seller pays notional × (1 − recovery), with recovery set by an auction. The buyer's economic result is similar.

What are the common CDS credit events?

Bankruptcy, failure to pay and restructuring are the usual ones. Sovereign contracts may also include repudiation or moratorium. The restructuring clause in the contract determines how restructuring is treated.