C r e d i t D e f a u l t S w a p ( C D S )

Overview
A credit default swap is a contract that provides insurance against the default of a particular entity.
The buyer of the CDS makes regular payments to the seller until either maturity of the contract or the
occurrence of a credit event (the entity defaults). In the event of default by the entity, it is assumed the CDS
buyer makes a claim on the notional value of the CDS from the seller, while the defaulted reference
obligation (bond or convertible bond) is transferred to the seller. The CDS buyer also pays any portion of
the payment that has accrued in the current period.
No Credit Event

Default BPS Fee on Notional

Default
Protection Protection
BUYER SELLER

Credit Event

Default BPS Fee on Notional

Default
Protection Defaulted Ref Bond Protection
BUYER SELLER
CDS Notional

Example
Suppose two parties enter into a CDS contract based on a notional of $100 million, the buyer agreeing to
pay 800,000 annually as protection against default of company ABC.
Note: The CDS buyer would usually hold ABC bonds in the amount of the CDS contract notional, though
this is not a requirement.
If 1.5 years into the contract ABC defaults, the CDS buyer receives $100 million (the CDS notional). The
CDS seller receives the ABC bond (which now may be worth 30 percent of its par value, for example).
Since the credit event terminates the CDS, the buyer is obligated to that portion of the payment that has
accrued in the payment period. If 6 months have passed since the most recent payment, and the buyer is
paying 800,000 annually, the buyer pays the seller 400,000 at termination of the CDS.

Credit Default Swap (Security)

To create a Credit Default Swap security:
• From the main window, click SecMaster=> New Security=> Credit=> Credit Default Swap.

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 Credit Default Swap Underlying Security Window

The following fields are of particular importance in setting up a Credit Default Swap:
Maturity - Maturity date of the CDS (YYYYMMDD).
CDS Spread (BPS) - Credit default swap spread. That is, the payment per year, as a percentage of notional
principal, that the CDS buyer makes to the CDS seller.
Payment Freq - Frequency at which the CDS buyer makes payments to the CDS seller.
Payment Type - Select the option that represents when end-of-month coupons are paid: Regular or End
of Month.
This setting is meaningful only when the payments occur at the end of the month, in
which case this setting resolves any ambiguity as to the meaning of user-entered dates.
For example, is the date April 30 intended to indicate the end of the month or regular
coupon payments on the 30th?
First Payment Date - Enter the first payment date (YYYYMMDD).
Issue Date - Enter the issue date (YYYYMMDD).
Day Count - Select the Day Count convention used to calculate accruals.
CDS (Notional Amt) - Enter the notional amount per CDS contract.
Trade Settle - Select the settlement rule applicable to trading of this security.

Pricing Environment
To access the Pricing Environment window:
• Click on the Environment button. The Pricing Environment window is displayed.

Credit Default Swap Security Pricing Environment

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The security’s Pricing Environment enables you to define the following pricing inputs:

Input Description
Model Pricing model used.
Yield The Yield input determines the riskless interest rate used and -- when set to CRating --
the probability density of default. That is, the credit spreads entered in the specified
matrix are used to determine the likelihood of default.
Credit Spread Use the Credit Spread input to add an additional credit spread on the Yield. The Credit
Spread entered is used to determine the likelihood of default. If Yield is set to CRating,
then the sum of spreads is used in the probability of default calculation.
Volatility Inactive.
Vol Spread Inactive.
Ref Bond Set Ref Bond to Symbol.
Enter the symbol of the reference obligation, a bond or convertible bond (or press F2 for
a lookup list), and then enter the Recovery Rate (%). This is the percentage that is
expected to be recovered on the reference bond in the event of default. The recovery
rate applies to the full life of the CDS.
For example, suppose the CDS is intended to provide insurance on a bond whose
symbol is ABC 5% 2006 and that in default, holders are expected to recoup 30 cents on
the dollar. You would enter ABC 5% 2006 in the symbol field and 30.0 in the Recovery
Rate (%) field.

For the CDS, the yield curve environment (yield curve + credit spread) should correspond to the yield
environment of the reference entity against which default protection is sought.

Credit Default Swap (Holding)

To create a CDS holding:
• From a portfolio, click New Holding=> Credit=> Credit Default Swap.
Create the CDS holding as you would any other security type.

Holding Inputs
When you price a CDS, these inputs are displayed in the holding window:
Accrued Payment - Payment accrued for the current period.
Expected Payoff - Expected payoff to the buyer from the seller.
Expected Payment - Expected payment to the seller from the buyer.

Portfolio Columns
SM Coupon - For a CDS security, this column displays the CDS Spread.

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Entering a CDS Order

Please refer to the CDS order form shown below:

CDS Order Window

Users will note that there is a limit price (Limit (USD))available for entering a market spread, or the
current quoted CDS spread. Should this spread be different from the spread specified on the CDS security
master screen, an immediate P&L value will be realized. Should you omit the limit spread when booking
the CDS order, it is assumed that the trade spread will be equal to the spread specified on the security
master screen, resulting in zero average cost.
The average cost of a CDS is expressed in economic (real dollar) terms.
The Quantity of a CDS order is typically 1.

To unwind a CDS, simply perform a reverse trade at a limit price equal to the current market spread. This
will transfer the current unrealized P&L of the CDS into realized (booked) P&L.

CDS Model: Calculation Notes

The CDS model relies on the probability of default and the expected recovery rate in the event of default.
The expected recovery rate is typically a value published by a rating agency, which the user enters in the
CDS security’s pricing environment.
The probability of default is calculated by the system, based on either the credit spreads entered in the
Credit Spread Matrix or the Credit Spread entered in the pricing environment (or a combination thereof).
When the Credit Spread Matrix is used, the full term structure of credit spreads is incorporated into the
calculation. The yield curve environment of the CDS (curve + spread) should mirror that of the reference
entity for which the default protection is sought. In this way, the CDS is able to calculate probabilities of
default within each coupon interval of the reference entity by making arbitrage arguments comparing the
riskless (base curve) and risky (base curve + spread) rates. These default probabilities are then used to

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calculate the expected present value of the CDS payments, and the expected present value of the CDS
payoff, with the fair value being the CDS spread that makes the value of the credit default swap zero:
Fair Value = Expected Present Value CDS Payoff / Expected Present Value CDS Payment
Note that the Imagine model assumes default can happen at any time between payments, using a grid size
of one month.

The reference entity is part of the pricing environment of the CDS in that it determines both the coupon
frequency for calculation of the default probability density on each interval and the accrued interest that
affects the claim made on default. In the absence of the reference entity in the pricing environment it is
assumed that the coupon frequency for calculation of default probability densities is the same as the CDS
payment frequency, and the accrued interest claimed in case of default is zero.

A recovery rate is also included in the environment of the CDS. The recovery rate affects both the default
probability densities of the CDS and the CDS payoff. These two effects work counter to each other and
users will note there is little effect on the CDS fair value in certain ranges of recovery rates.

CDS P&L
The CDS allows users to view and aggregate P&L numbers based upon current CDS spreads quoted by the
market. The current dollar value of a CDS in economic terms is given by:
CDS $Value = CDS Notional * Expected Present Value of CDS Payments *
(CDS market spread – CDS security master spread)
where the CDS security master spread is the contract spread and the CDS market spread is given by the
market, either from the Imagine market quotation screen, or fair value, depending upon mark accounting
settings.
Although the accrued interest of the reference entity affects the fair value of the CDS, the CDS itself
accrues negative interest in the form of payments from the buyer to the seller. Thus for the CDS, standard
columns used to display accrued interest indicate the accrued payments from buyer to seller of default
protection. These accrued adjustments are applied on a nightly basis as booked P&L adjustments.

CDS Spreads

Given that there are numerous spreads associated with a CDS, a summary is given here:
a) Contract Spread (Security Window) – This is the spread (in basis points) of the CDS from buyer of
CDS to seller of default protection. This spread is an inherent part of the CDS contract and should remain
constant through the life of the CDS.
b) Environment Spread (Environment Window) – This is the spread used to simulate the yield curve
pricing environment of the reference (default protected) entity. This spread can change over time if the
reference entity’s credit rating increases or declines. The yield curve pricing environment of the CDS
should simulate the yield curve pricing environment of the reference entity.
c) Market Spread – This is the spread quoted by the market. For the CDS, this price can be specified on
the Imagine Quote screen for the market symbol of the CDS or uploaded for the market symbol of the
CDS. Depending on your mark accounting settings, this market spread may fall back to fair spread if a
market spread is unavailable.
As with any OTC security, users may prefer to mark the CDS security type to Fair for calculation of live
unrealized P&L. This can be accomplished by setting the Live P&L Side to Fair in the CDS security
type’s Mark Accounting window (Config=> Security Codes: CDS).
d) Fair Spread – This is the spread, at any given time, that makes the value of the CDS contract zero. This
is a calculated value, displayed in the Fair column of the portfolio.

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