A credit derivative transfers specified credit-related cash flows without necessarily transferring ownership of the reference asset. The reference entity is the borrower whose credit drives the payoff; the counterparty is the institution promising the derivative payment. Hedging the first can create exposure to the second. A hedge can also leave maturity, restructuring, currency, deliverable and funding mismatches.
A credit default swap (CDS) exchanges periodic premiums for a payment following a contractually defined credit event. The protection buyer pays the premium and the seller bears the specified reference credit loss. Failure to pay, bankruptcy and restructuring may be covered, depending on the contract. A reference-entity downgrade can change a CDS's market value without triggering settlement.
For physical settlement, the buyer delivers an eligible obligation and receives par. For cash settlement, the payment is notional times one minus the settlement recovery price. On $10M notional with a 35% recovery price, cash protection pays $6.5M. In a physical settlement, delivering an obligation worth $3.5M in exchange for $10M has the same net economic value before delivery costs.
Common mistakes
- Reversing correlation signs. A long senior investment is generally short correlation under fixed marginal default assumptions. Senior protection is the opposite position. Translate the trade into investment or protection before assigning a sign.
- Multiplying by tranche width twice. Example 1 already specifies $500M of tranche notional. The 62.5% impairment produces $312.5M, not $25M.
- Treating hazard as PD. Hazard is a conditional intensity per year. Convert it to a horizon default probability using survival; 200 basis points of spread is neither hazard nor PD without additional assumptions.
Bottom line
- CDS transfers specified credit-event loss; TRS transfers the reference asset's full economic return.
- Value premium and protection legs using market-consistent default probabilities and stated recovery and discounting.
- Fixed coupons are reconciled with current market value through upfront payments.
- CDS forwards create future commitments; payer and receiver options create directional rights.
Exam shortcut
Before calculating a tranche loss, label the notional as pool or position. Before answering a correlation question, label the position as investment or protection. For a CDS valuation, separate the premium annuity, period default masses and upfront sign. When subtracting base slices, put both legs on the same pool notional first.
The full lesson (about 2,998 words, 20 min read) adds 3 worked examples, all 6 common mistakes, a self-check, free in the app.
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