{"id":21783,"date":"2021-09-29T05:35:48","date_gmt":"2021-09-29T05:35:48","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=21783"},"modified":"2026-01-21T14:28:25","modified_gmt":"2026-01-21T14:28:25","slug":"credit-events","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/credit-events\/","title":{"rendered":"Credit Events"},"content":{"rendered":"<p><script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"ImageObject\",\n  \"@id\": \"https:\/\/analystprep.com\/study-notes\/images\/credit-events-physical-settlement\",\n  \"contentUrl\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement-1536x601.jpg\",\n  \"url\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement-1536x601.jpg\",\n  \"caption\": \"Credit Events \u2014 Physical Settlement\",\n  \"width\": 1536,\n  \"height\": 601,\n  \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\n  \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\n  \"creditText\": \"AnalystPrep Design Team\",\n  \"creator\": {\n    \"@type\": \"Organization\",\n    \"name\": \"AnalystPrep\"\n  },\n  \"isPartOf\": {\n    \"@type\": \"WebPage\",\n    \"@id\": \"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/credit-events\/\"\n  }\n}\n<\/script><\/p>\n<p><script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"ImageObject\",\n  \"@id\": \"https:\/\/analystprep.com\/study-notes\/images\/credit-events-cash-settlement\",\n  \"contentUrl\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement-1536x533.jpg\",\n  \"url\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement-1536x533.jpg\",\n  \"caption\": \"Credit Events \u2014 Cash Settlement\",\n  \"width\": 1536,\n  \"height\": 533,\n  \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\n  \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\n  \"creditText\": \"AnalystPrep Design Team\",\n  \"creator\": {\n    \"@type\": \"Organization\",\n    \"name\": \"AnalystPrep\"\n  },\n  \"isPartOf\": {\n    \"@type\": \"WebPage\",\n    \"@id\": \"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/credit-events\/\"\n  }\n}\n<\/script><br \/>\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"What is the recovery rate for CDS contracts when multiple bonds are outstanding?\",\n    \"text\": \"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. What is the recovery rate for both CDS contracts?\",\n    \"answerCount\": 3,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The recovery rate is 30%. In a credit event, CDS settlement is based on the cheapest-to-deliver obligation. Since Bond A is trading at 30% of par, it determines the recovery rate used for both CDS contracts.\"\n    },\n    \"suggestedAnswer\": [\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"40%.\"\n      },\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"50%.\"\n      }\n    ]\n  }\n}\n<\/script><\/p>\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/rtmE95_MpsQ\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<p>A <em><strong>credit event<\/strong><\/em> 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.<\/p>\n<p>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:<\/p>\n<h3>Bankruptcy<\/h3>\n<p>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.<\/p>\n<h3>Failure to Pay<\/h3>\n<p>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.<\/p>\n<h3>Restructuring<\/h3>\n<p>This involves altering the terms of the obligation involuntarily to make the new terms less attractive to the debt holder. These events may include:<\/p>\n<ul>\n<li>Reduction in the interest rate.<\/li>\n<li>Rescheduling the payment of interest or principal.<\/li>\n<li>Change of currency.<\/li>\n<li>Change in the level of seniority.<\/li>\n<\/ul>\n<h3>Repudiation\/Moratorium<\/h3>\n<p>This involves disputing the validity of the contract or imposing a temporary suspension of activity on the reference entity.<\/p>\n<h2>Settlement Protocols<\/h2>\n<p>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.<\/p>\n<h3>Physical Settlement<\/h3>\n<p>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.<\/p>\n<h3><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter size-full wp-image-26615\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement.jpg\" alt=\"Physical Settlement\" width=\"1590\" height=\"622\" srcset=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement.jpg 1590w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement-300x117.jpg 300w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement-1024x401.jpg 1024w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement-768x300.jpg 768w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement-1536x601.jpg 1536w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Physical-Settlement-400x156.jpg 400w\" sizes=\"auto, (max-width: 1590px) 100vw, 1590px\" \/>Cash Settlement<\/h3>\n<p>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.<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter size-full wp-image-26616\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement.jpg\" alt=\"Cash Settlement\" width=\"1590\" height=\"552\" srcset=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement.jpg 1590w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement-300x104.jpg 300w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement-1024x356.jpg 1024w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement-768x267.jpg 768w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement-1536x533.jpg 1536w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/09\/Cash-Settlement-400x139.jpg 400w\" sizes=\"auto, (max-width: 1590px) 100vw, 1590px\" \/>The <em><strong>recovery rate<\/strong><\/em> is the proportion of the defaulted amount that can be recovered through bankruptcy proceedings or some other settlement form. The <em><strong>payout ratio<\/strong><\/em>, which is the complement of the recovery rate, is the estimate of the expected credit loss.<\/p>\n<p>$$ \\text{Payout ratio}=1-\\text{Recovery rate} $$<\/p>\n<p>The rest of the settlement amount is determined by an auction involving major banks and dealers to choose the cheapest-to-deliver defaulted debt.<\/p>\n<p>The payout amount is the product of the payout ratio and the notional amount.<\/p>\n<p>$$ \\text{Payout amount}=\\text{Payout ratio} \\times \\text{Notional amount} $$<\/p>\n<p>&nbsp;<\/p>\n<blockquote>\n<h2>Question<\/h2>\n<p>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 <em>closest to<\/em>:<\/p>\n<ol type=\"A\">\n<li>30%.<\/li>\n<li>40%.<\/li>\n<li>50%.<\/li>\n<\/ol>\n<h4>Solution<\/h4>\n<p><strong>The correct answer is A.<\/strong><\/p>\n<p>The recovery rate is 30% for both CDS contracts since Bond A is the cheapest- to-deliver obligation.<\/p>\n<\/blockquote>\n<p>Reading 32: Credit Default Swaps<\/p>\n<p><em>LOS 32 (b) Describe credit events and settlement protocols with respect to CDS.<\/em><\/p>\n\n            <div \n                class=\"elfsight-widget-pricing-table elfsight-widget\" \n                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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&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,472],"tags":[216,548],"class_list":["post-21783","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-fixed-income","tag-cfa-level-2","tag-fixed-income","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Credit Events - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Learn about types of credit events such as bankruptcy, failure to pay, restructuring, and repudiation\/moratorium, as defined by the ISDA.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/credit-events\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Credit Events - 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