7/16/22, 4:19 PM A Beginner’s Guide to Credit Default Swaps (Part 3) – Rich Newman

Rich Newman

A Beginner’s Guide to Credit Default Swaps (Part 3)


beginners guide, cds, credit default swap, derivatives, introduction, tutorial 
August 4,
2011August 8, 2011 4 Minutes
Introduction

Part 1 of this series of articles (https://richnewman.wordpress.com/2007/12/09/a-beginners-guide-to-

credit-default-swaps/) described the basic mechanics of a credit default swap.

Part 2 (https://richnewman.wordpress.com/2011/07/19/a-beginner%e2%80%99s-guide-to-credit-default-
swaps-part-2/) started to describe some of the changes in the market since part 1 was written.  This part
will continue that description by describing the upfront fee that is now paid on a standard CDS contract,
and the impact of the changes on how CDS are quoted in the market.

Standard Premiums mean there is a Fee

Part 1 discussed how CDS contracts have been standardized.  One of the ways in which they have been
standardized is that there are now standard premiums.

Now consider the case where I buy protection on a five-year CDS.  I enter into a standard contract with a
premium of 500 basis points (5%).  It may be that the premium I would have paid under the old
nonstandard contract for the same dates and terms would have been 450 basis points.  However, now
I’m paying 500 basis points.

Clearly I need to be compensated for the 50 bps difference or I won’t want to enter into the trade under
the new terms.

As a result an upfront fee is paid to me when the contract is started.  This represents the 50 basis points
difference over the life of the trade, so that I am paying the same amount overall as under the old
contract.

Note that in this case I (the protection buyer) am receiving the payment, but it could easily be that I pay
this upfront fee (if, for example, the nonstandard contract would have traded at 550 bps).

Upfront Fee Calculation

The calculation of the fee from the ‘old’ premium (spread) is not trivial.  It takes into account
discounting, and also the possibility that the reference entity will default, which would mean the
premium would not be paid for the full life of the trade.  However, this calculation too has been
standardized by the contracts body (ISDA).  There is a standard model that does it for us.

The Full First Coupon means there is a Fee

In the example in part 1 I discussed how I might pay for a full three months protection at the first
premium payment date for a CDS trade, even though I hadn’t had protection for three months.
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Once again I need compensation for this or I will prefer to enter into the old contract.  So once again
there is a fee paid to me when I enter into the trade.

This is known as an ‘accrual payment’ because of the similarity to accrued interest payment for bonds. 
Here the calculation is simple: it’s the premium rate applied to the face value of the trade for the period
from the last premium payment date to the trade date.

That is, it’s the amount I’ll be paying for protection that I haven’t received as part of the first premium
payment.  Note no discounting is applied to this.

Upfront Fee/Accrual Payment

So in summary the new contract standardization means that a payment is now always made when a
standard CDS contract is traded.

Part of the payment is the upfront fee that compensates for the difference between the standard
premium (100 or 500 bps in North America) and the actual premium for the trade.  This can be in either
direction (payment from protection buyer to seller or vice versa).  Part of the payment is the accrual
payment made to the protection buyer to compensate them for the fact that they have to make a full first
coupon payment.

How CDS are Quoted in the Market

Prior to these changes CDS were traded by simply quoting the premium that would be paid throughout
the life of the trade.

With the contract standardization clearly the premium paid through the life of the trade will not vary
with market conditions (it will always be 100 or 500 bps in North America, for example), so quoting it
makes little sense.

Instead the dealers will quote one of:

a) Points Upfront

‘Points upfront’ or just ‘points’ refer to the upfront fee as a percentage of the notional.  For example, a
CDS might be quoted as 3 ‘points upfront’ to buy protection.  This means the upfront fee (excluding the
accrual payment) is 3% of the notional.  ‘Points upfront’ have a sign: if the points are quoted as a
negative then the protection buyer is paid the upfront fee by the protection seller.  If the points are
positive it’s the other way around.

b)  Price

With price we quote ‘like a bond’. We take price away from 100 to get points:

That is, points = 100 – price.  So in the example above where a CDS is quoted as 3 points to buy
protection, the price will be 97.   The protection buyer still pays the 3% as an upfront fee of course.

c)  Spread

Dealers are so used to quoting spread that they have carried on doing so in some markets, even for
standard contracts that pay a standard premium.  That is they still quote the periodic premium amount
you would have been paying if you had bought prior to the standardization.  As already mentioned,
there is a standard model for turning this number into the upfront fee that actually needs to be paid.

Conclusion

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This part concludes the discussion of the changes in the mechanics of CDS trading since 2007.  As you
can see, in many ways the standardization of the CDS market has actually made it more complicated. 
The things to remember are that premiums, premium and maturity dates, and the amounts paid at
premium dates have all been standardized in a standard contract.  This has meant there is an upfront fee
for all standard CDS, and that they are quoted differently in the market from before.  It has also meant
that CDS positions can be more easily netted against each other, and that the mechanics of calculating
and settling premiums have been simplified.

Part 4 of this series (https://richnewman.wordpress.com/2011/08/08/a-beginners-guide-to-credit-default-

swaps-part-4/) will examine some of the other changes since 2007, and changes that are coming.

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15 thoughts on “A Beginner’s Guide to Credit Default

Swaps (Part 3)”

Rajesh says:
November 12, 2011 at 10:08 am
Excellent Article. Suck a complex subject is very well explained

 Reply
Hatem Ben-Ameur, Professor, Decision sciences, HEC Montréal says:
October 5, 2021 at 2:03 pm
Dear Rich Newman,

Thank you for this text on CDSs. Please, can you explain to me how Bloomberg quote CDS up-
front payments? I’m trying to evaluate CDS contracts using a structural model à la Geske. For
simplicity, I assumed that the up-front payment of a CDS, quoted by Bloomberg, is associated to a
fixed coupon (500 bp) paid quarterly by the protection buyer in case of survival and a loss given
default (60% of par) received in case of default.

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Is my assumption correct?

My model gives CDS up-front payments largely different from their quoted counterparts.

 Reply
richnewman says:
October 6, 2021 at 10:48 am
I’m not sure I can be much help here, sorry. I no longer have access to Bloomberg, and it’s a
long time since I’ve had to struggle to get a spreadsheet to agree.

Having said that, I think your assumptions are correct and I don’t think it should be
particularly difficult to do this. There should be a CDS pricing page (CDSW?) that lets you
price a CDS. It shows lots of useful information that means it is easier to replicate, including
the credit and IR curves being used and spread as well as price. Apologies if you’re already
looking at that and confused, but if you’re not that should help.

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ershad says:
January 26, 2013 at 10:31 pm
Very well explained. I have struggled to understand the price quotes. Many thanks

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surekha says:
June 13, 2016 at 8:36 pm
why is notional recorded as negative when buying protection.

 Reply
Anonymous says:
March 20, 2019 at 10:57 am
because its a short position

 Reply
Ash says:
June 7, 2017 at 4:46 am
Hi whats the logical explanation for why when recovery rate goes up default probabilit goes up as
well. i can see that that is the case with the mathematical formula

1-e^(-S * t/ (1-R)) but is there an intuitive way to think about this?

Ash

 Reply
Vishal Pagar says:
November 24, 2019 at 2:51 pm
If price quoted in PTS (points upfronts), how to get the equivalent in bps?

Is 3 points upfront is equivalent to 300 BPS?

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 Reply
richnewman says:
November 25, 2019 at 3:44 pm
It’s not as simple as 3 points = 300 bps.

As discussed above, with standardization of contracts upfront fees are quoted in points (PTS).
These represent a one-off payment at the start of a standard contract. Before standardization CDS
were quoted on a spread basis in basis points (bps). This represented the premium paid
throughout the life of the contract.

As mentioned above there is a standard model from ISDA that is used to go from one to the other.

 Reply
Vishal Pagar says:
November 27, 2019 at 5:24 pm
Thanks for the detail explanation!

Blog at WordPress.com.

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