Credit Default Swaps (CDS) and Credit Derivatives › Structure of a Credit Default Swap
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A credit default swap is a bilateral contract between two parties: the protection buyer and the protection seller. The protection buyer seeks insurance against default of a reference entity (a corporation, sovereign, or other borrower), while the protection seller assumes this risk in exchange for periodic premium payments. This arrangement mirrors traditional insurance contracts in many respects, though important differences exist in how these instruments are regulated and traded.
The contract specifies several key terms:
- Reference entity: The corporation, sovereign, or other borrower whose credit risk is being transferred
- Notional principal: The face value of protection purchased (e.g., \$10 million)
- CDS spread: The annual premium paid by the protection buyer, expressed in basis points of the notional
- Maturity: The length of the contract, typically 1, 3, 5, 7, or 10 years
- Credit events: The specific events that trigger the protection payment
Premium Leg and Protection Leg
A CDS has two legs that determine its value, similar to how an interest rate swap has fixed and floating legs. Understanding these two components is essential because CDS pricing fundamentally comes down to equating the expected present value of payments flowing in each direction.
The premium leg represents the periodic payments from the protection buyer to the protection seller. If the CDS spread is (expressed as a decimal) and the notional is , the protection buyer pays approximately per year, typically in quarterly installments. These payments continue until either the contract matures or a credit event occurs. The premium leg thus resembles a stream of coupon payments on a bond, with one difference: the payments cease immediately upon default, so the expected value of this leg depends on survival probabilities.
The protection leg represents the contingent payment from the protection seller to the protection buyer if a credit event occurs. Upon default, the protection seller compensates the buyer for the loss on the reference obligation. If the recovery rate is (the fraction of face value recovered after default), the protection seller pays . This payment represents the actual economic loss suffered by a bondholder, making the CDS an effective hedge for someone holding the reference entity's debt.