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Why CDS Upfront Cash Settlement Deducts Accrued Coupon

Article Quant Q&A · Author: Lucas Dias
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Summary

The document asks how the upfront amount for a credit default swap is determined and why the cash exchanged at settlement differs from the quoted principal amount. The questioner understands the principal as the difference between the present values of the default and premium legs, and compares that amount with a bond’s dirty price. The confusion is why accrued coupon is subtracted when banks calculate the CDS cash payment.

The answer explains that the standard coupon began accruing before the pricing date. The buyer or seller therefore does not owe the portion of the coupon that accrued before the trade date; the past accrual is deducted from the upfront amount. The example refers to a coupon period beginning on September 22 and pricing on November 5, with 45 days of elapsed accrual. The text gives this brief settlement explanation but no full valuation derivation or detail on conventions that may vary by contract.

Key ideas

  • The CDS upfront settlement amount is adjusted for coupon accrued before the pricing date.
  • The quoted principal and the cash amount exchanged can differ because of that accrued coupon.
  • The answer attributes the deduction to the elapsed portion of the standard coupon period.
  • The example identifies 45 days of past accrual between the stated coupon start and pricing dates.
  • The document does not provide a full valuation derivation or discuss convention variations.

Tags

Fixed incomeDerivatives pricingRisk management
Full text
# CDS upfront fee in CDSW


# CDS upfront fee in CDSW












I want to understand how the upfront fee that is paid/received at the start of a CDS is calculated. My understanding is that it should equal the difference between the present values of the two legs of the CDS — the default leg and the premium leg — weighted by their respective default probabilities. This difference is what Bloomberg shows as “Principal”, for example USD 192,672 in the picture, which can be computed as (100 − Price) × Notional / 100, as shown in Hull’s book.

However, when I trade this instrument with banks, they pay/charge me the cash amount, which is obtained by subtracting the accrued coupon. What I don’t understand is why the accrual needs to be deducted, since the Principal already represents the difference in present values between the two legs, so what needs to be paid/received to make mtm equals 0 in the beginning. imo Principal should correspond to the dirty price of a bond, while the cash amount would correspond to the clean price.

## Answer by oronimbus (score 1)

https://quant.stackexchange.com/a/85188

Because the CDS coupon starts accruing on the 22nd Sept and is priced as of 5th November -- you don't need to pay the part of the standard coupon that lies in the past (=45 days).

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.