A credit protection payment is the amount a protection seller owes a protection buyer when the covered credit event and settlement conditions of their contract are satisfied. In a credit default swap (CDS), this payment can offset a credit loss. Its size depends on the settlement terms; receiving it does not establish that the buyer made a profit.
How USD 10 million becomes USD 6 million
Consider a fictional CDS with USD 10 million notional. Stipulate a covered event, cash settlement, satisfaction of every required settlement condition and performance by the seller. The contract's reference settlement price is 40% of par. This is a supplied scenario input, not an observed auction result or a recovery forecast.
For this cash-settlement convention, let be notional and the reference price expressed as a fraction of par:
Here , so
The reference amount is USD 4 million; subtracting it from USD 10 million gives the payment. At settlement the buyer receives USD 6 million and the seller pays USD 6 million. The notional is the calculation scale, not the amount of cash transferred.
Stipulated covered-event cash settlement, assuming every required condition is met and the seller performs. The USD 4 million is a reference amount, not a separate transfer to the buyer.
Cash settlement and physical delivery have different gross transfers
In cash settlement, the parties use the contractual valuation mechanism to determine a cash amount; the buyer does not deliver a bond for this settlement. An auction may supply the price if the contract provides for auction settlement. The ISDA disclosure annex, “Settlement Methods”, explains auction, cash, physical and fallback arrangements.
For a separate physical-settlement illustration, stipulate delivery of eligible debt with USD 10 million face value against USD 10 million cash. If that debt is worth USD 4 million at delivery, exchanging it for par provides USD 6 million of economic protection before other costs. The gross cash payment is USD 10 million, accompanied by the debt transfer. Calling the physical cash payment USD 6 million would omit the delivery leg. This comparison follows the distinction in Bomfim's Federal Reserve primer, §4; actual deliverability and payment terms govern each trade.
A settlement receipt is only one line of the trade
The USD 6 million above excludes the CDS premium, any upfront amount, funding, tax, discounting and collateral flows. Excluding these items from an illustration does not make them zero in a real contract. A trading-profit calculation needs the relevant receipts, costs, positions and valuation dates.
The settlement price also need not equal the eventual recovery rate on a bond the buyer owns. A different claim, seniority or valuation date can leave a basis risk between the CDS receipt and the investor's loss. The advanced lesson CDS overlays and recovery/documentation basis develops that residual in convertible hedges; the full lesson requires membership and has a public preview.
Finally, a loss on a bond is not itself proof that a CDS payment is due. The specified credit event, applicable notices or determinations, settlement method and other contractual conditions must be satisfied. An amount owed is also not cash received if the seller fails to perform: protection leaves counterparty credit risk.
Sources
- ISDA, Credit Derivatives Disclosure Annex, July 2021, pp. 1–2 and “Settlement Methods,” pp. 10–11. ISDA-authored text hosted by Deutsche Bank; the transaction's governing documents control.
- Antulio N. Bomfim, Credit Default Swaps, FEDS 2022-023, §4: settlement mechanics and contractual obligations.
- John C. Hull, Options, Futures, and Other Derivatives, ninth Global Edition (Pearson, 2018), §25.1, pp. 594–596: notional, physical/cash settlement and premium cash flows.