How Standard CDS Credit-Event Settlement Works
Summary
The document explains why standard CDS settlement after a credit event does not generally depend on the trade’s original coupon or upfront payment. Those amounts reflect the trade’s earlier mark-to-market and are treated as historical once the event occurs. The settlement process instead establishes whether and when a credit event occurred, determines the defaulted debt’s auction price, and calculates the contract’s event-related cash flows.
The protection buyer owes accrued premium through the event date, while the seller owes the notional; the buyer then delivers eligible debt or pays its auction-established value under cash settlement. Margins are adjusted and cash flows are netted. The discussion distinguishes these standard terms from custom OTC provisions, such as a specified fixed recovery. It outlines the usual process but does not address every contract variation or the mechanics of a particular auction, and the original question’s example is not independently worked through.
Key ideas
- Standard CDS credit-event settlement follows contract terms and does not simply add the pre-event mark-to-market to the default payment.
- A Determinations Committee decides whether a credit event occurred and its date.
- A credit-event auction establishes the price of defaulted debt used for cash settlement.
- Accrued premium is payable through the event date, and the seller owes the notional.
- Physical delivery, auction-based cash settlement, or specified custom recovery terms determine the buyer’s debt-related obligation.
Tags
Full text
# Agreement on cash settlement of a CDS # Agreement on cash settlement of a CDS Suppose the 5y mid-market-rate CDS price for AlphaCorp is 50bps. The below CDS are in 1mm$ notional. > InvestorA buys protection from BankA at a fixed coupon of 50bps. InvestorA has no upfront fee. > InvestorB buys protection from BankB at a fixed coupon of 75bps. InvestorB receives an upfront fee of 10,000 \$. Under the terms of the ISDA master agreement InvestorB will post $10,000 as collateral against their liability. > InvestorC buys protection from BankC at a fixed coupon of 25bps. InvestorC pays an upfront fee of 10,000 \$. Under the terms of the ISDA master agreement InvestorC will receive $10,000 in collateral securing their asset. One week later AlphaCorp has a default event. The final price is deemed at 35.0, so a compensation sum is payable to the tune of 650,000 \$, to each investor from each bank. It is my understanding that this default sum will also include the PV of the trade. So, if the CDS at default was still priced with 50bps, > the NPV of InvestorA's CDS is zero so she receives 650,000. > the NPV of InvestorB's CDS is -10,000 so she receives 640,000 (but she also received 10,000 a week ago), and collateral is returned. > the NPV of InvestorC's CDS is +10,000 so she receives 660,000 (but she also paid 10,000 a week ago), and collateral is returned. Net net, it doesn't appear to matter what coupon the CDS was struck at - none of the Investors are advantaged or disadvantaged by any option. But, all of this seems to hinge on the determination of the final value of the CDS, which may be difficult to value after such a default event has occurred. In particular, the Banks and Investors may disagree on the mid market NPV of the existing obligation. Is this a roughly accurate picture of reality? Is there a standard, transparent settlement procedure for evaluating the NPV of the contract, so that all parties can agree? Am I missing anything blindingly obvious? ## Answer by Dimitri Vulis (score 1, accepted) https://quant.stackexchange.com/a/80853 CDS are OTC, so the parties can agree to any custom terms they like. However this isn't quite how standardized ISDA contracts work. The mtm of the swap before the event, and the historical upfront fee don't matter at all, water under the bridge. Rather, after the event: The Determinations Committee votes that an event has occurred, and on what date. An auction is held to determine the price of the defaulted bond. The protection buyer owes to the protection seller the periodic payment accrued until the day of the event. (This is different from bonds, whose accrued is wiped out.) The protection seller owes to the protection buyer the notional. The protection buyer owes to the protection seller either (physical settlement) debt that is pari passu with the reference obligation, face value = notional; or (cash settlement) the pv of this debt, established at an ISDA-run auction; or (very rare, not a standard contract!) some other contractually specified "fixed recovery", which may be 0. The margins associated with the swap(s) are adjusted, and all the cash flows are netted. Some useful readings: https://www.investopedia.com/articles/bonds/09/what-happens-to-single-name-cds.asp not great Investopedia article https://www.isda.org/traditional-protocol/big-bang-protocol/ ISDA 2009 https://www.creditfixings.com/CreditEventAuctions/static/credit_event_auction/docs/credit_event_auction_primer.pdf Markit / CreditEx credit event auction primer https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_quarterly/2019/q2/sultanum.pdf Paulos, Sultanum, Tobin paper with some history https://www.cdsdeterminationscommittees.org/ Determinations Committee home page https://www.cdsdeterminationscommittees.org/cds/rite-aid-corporation/ Example committee decision that Ride Aid had an event https://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=RAD Example Right Aid auction results
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