Credit Events

Credit Events

A credit event is an event that triggers the default of a bond. The CDS seller must purchase the defaulted bonds at their face value from the CDS buyer in case of a credit event.

The International Swaps and Derivatives Association (ISDA) is the unofficial governing body of the CDS market. The ISDA outlines the following types of credit events:


Bankruptcy is a legal procedure that forces creditors to defer their claims. This can happen when the reference entity becomes insolvent or is unable to fulfill its debt obligations.

Failure to Pay

The reference entity fails to meet one or more payment obligations (principal or interest) after applying any applicable grace period without filing for formal bankruptcy.


This involves altering the terms of the obligation involuntarily to make the new terms less attractive to the debt holder. These events may include:

  • Reduction in the interest rate.
  • Rescheduling the payment of interest or principal.
  • Change of currency.
  • Change in the level of seniority.


This involves disputing the validity of the contract or imposing a temporary suspension of activity on the reference entity.

Settlement Protocols

In a credit event, both the buyer and seller of the CDS have the right, but not the obligation to settle. CDS settlement can be done in the form of a physical or cash delivery.

Physical Settlement

Physical settlement involves the actual delivery of the debt instrument in exchange for a payment by the credit protection seller of the notional amount of the contract. This mode of settlement is uncommon.

Physical SettlementCash Settlement

Cash delivery is the most common settlement method for CDS contracts. Here, the credit protection seller pays cash to the credit protection buyer following a credit event.

Cash SettlementThe recovery rate is the proportion of the defaulted amount that can be recovered through bankruptcy proceedings or some other settlement form. The payout ratio, which is the complement of the recovery rate, is the estimate of the expected credit loss.

$$ \text{Payout ratio}=1-\text{Recovery rate} $$

The rest of the settlement amount is determined by an auction involving major banks and dealers to choose the cheapest-to-deliver defaulted debt.

The payout amount is the product of the payout ratio and the notional amount.

$$ \text{Payout amount}=\text{Payout ratio} \times \text{Notional amount} $$



A company with two subordinated unsecured senior debts outstanding has filed for bankruptcy, triggering CDS contracts. Bond A is trading at 30% of par, and Bond B is trading at 40% of par. The recovery rate for both CDS contracts is closest to:

  1. 30%.
  2. 40%.
  3. 50%.


The correct answer is A.

The recovery rate is 30% for both CDS contracts since Bond A is the cheapest- to-deliver obligation.

Reading 32: Credit Default Swaps

LOS 32 (b) Describe credit events and settlement protocols with respect to CDS.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep

    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    Crisp and short ppt of Frm chapters and great explanation with examples.