Read the CDS protection and its remaining risks

Learning goals

• Calculate the simplified CDS protection settlement.
• Explain why the protection buyer under the contract applies to this case.
• Identify the case-specific assumption or failure mode before taking action.

Draft · approximately 35 minutes, excluding further revision.

Shared case and decision context

An investor buys CDS protection on notional 5 million. A covered credit event occurs and auction recovery is 35%. Use a simplified cash settlement with no accrued premium adjustment. The seller is a separate counterparty and can itself default.

Economic or professional mechanism

The protection buyer pays a premium in exchange for a contingent payment defined by contract. The protection seller assumes credit exposure; notional is not the same as market value or expected loss. Contract definitions, reference obligation, deliverability and settlement procedures matter. Buying protection can hedge credit but introduces counterparty and basis risk.

Apply, challenge and communicate

The simplified protection payment is 3.25 million. A bond-plus-CDS package may retain funding, liquidity and bond/CDS basis risk; matching issuer names alone is not a perfect hedge. Changes in spread affect mark-to-market even when no credit event occurs.

Treat the bond-CDS basis as an implementation problem

A bond’s credit spread can differ from a maturity-matched CDS spread because of funding, liquidity, deliverability, counterparty exposure and contract terms. Buying a bond and protection when the bond spread is wider may appear to capture basis, but financing and settlement risks can consume or reverse it. Specify actual executable prices and hedge ratios. A basis trade is not risk-free merely because both instruments reference the same company.

Formula and assumptions

Protection settlement=notional*(1−auction recovery)

Case analysis with explicit assumptions

1. An investor buys CDS protection on notional 5 million. A covered credit event occurs and auction recovery is 35%. Use a simplified cash settlement with no accrued premium adjustment. The seller is a separate counterparty and can itself default.
2. Method: Protection settlement=notional*(1−auction recovery)
3. Case result: 3.25 million. The simplified protection payment is 3.25 million. A bond-plus-CDS package may retain funding, liquidity and bond/CDS basis risk; matching issuer names alone is not a perfect hedge. Changes in spread affect mark-to-market even when no credit event occurs.

Errors to catch

• Do not replace the stated assumptions with an unstated shortcut. Reconcile units, timing and the claim being valued or duty being assessed.
• Always expected loss is not a defensible conclusion for these case facts.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.cfainstitute.org
• Reference · www.bis.org