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101 Concepts for the Level I Exam

Essential Concept 74: Credit Events and Settlement Protocols

Credit event is an event that defines default by the reference entity. When a credit event occurs, the protection seller makes a payment to the protection buyer.

Three general types of credit events include:

  • Bankruptcy
  • Failure to pay
  • Restructuring

If credit event has occurred, two parties to a CDS have the right to settle the CDS. Settlement can happen in two ways:

  • Physical settlement: The debt instrument (reference obligation) is delivered by the protection buyer to the protection seller in exchange for a payment equal to the notional amount of the CDS contract
  • Cash settlement: The credit protection seller pays cash to the credit protection buyer as determined by the cheapest-to-deliver obligation of the reference entity.

Default does not mean that the creditor will lose the entire amount owed as a portion of the loss could be recovered. The recovery rate is the percentage of the loss recovered. The payout ratio is an estimate of the expected credit loss.

Payout ratio = 1 – recovery rate (%)

Payout amount = Payout ratio * notional amount

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