A hedge fund that owns none of a company's bonds can still collect when that company files for bankruptcy. That is not a loophole in the credit default swap market. It is the design.
A credit derivative is a derivative whose underlying is a measure of a borrower's credit quality. Four types exist: total return swaps, credit spread options, credit-linked notes, and credit default swaps. Only the last is liquid enough to dominate the market.
A credit default swap (CDS) is a contract between a credit protection buyer and a credit protection seller. The buyer makes a series of fixed periodic payments and receives, in return, a promise of compensation for credit losses on a third-party borrower. Once a credit event occurs, the buyer's payments stop and the seller pays.
The structure resembles a put option. The buyer pays premium and, on default, collects par less the recovery value. Between now and default, the contract still moves. A perceived deterioration in credit quality raises the value of protection long before any payment is missed.
Common mistakes
- Paying off the bond you own. The payout is set by the cheapest-to-deliver obligation of equal or higher seniority. Holding a bond at 40% of par when the cheapest deliverable trades at 30% still yields a 70% payout, not 60%. A subordinated bond at 20% does not qualify at all.
- Getting the upfront sign backwards. When the credit spread is below the fixed coupon, the seller pays the buyer. A 50 bp spread against a 100 bp coupon at duration 4 gives an upfront of −2%, and the price is 100 − (−2) = 102.
- Flipping long and short. The buyer of single-name protection is short credit, but the buyer of an index CDS position is long credit exposure. Candidates who translate "buy" as "long credit" in both cases lose the sign on the whole trade.
Bottom line
- Payoff basis: settlement uses the cheapest-to-deliver obligation of equal or higher seniority, not the bond you own
- Payout math: payout = LGD × notional, where LGD = 1 − recovery rate set by the ISDA auction
- Credit events: bankruptcy, failure to pay, and involuntary or coercive restructuring, declared by a 15-member Determinations Committee needing 12 votes
- Standard terms: 1% coupon for investment grade, 5% for high yield; 20th of March, June, September, December; 5-year most liquid
Exam shortcut
Write "(spread − coupon) × duration" in the margin before reading the choices. It answers upfront, price, and mark-to-market questions in one line, and the sign tells you who pays. For any settlement stem, hunt the words "cheapest to deliver" and "senior"; if a distractor uses a subordinated bond's price, it is wrong on eligibility, not on arithmetic. For probability stems, multiply survival, never add default.
The full lesson (about 2,967 words, 20 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- credit default swaps
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