A fund bought Rs 25 crore of CDS protection at 200 bp running. The reference company defaults 40 days after the last coupon date and the auction sets recovery at 35%. What does the seller pay, and what accrued premium does the buyer owe?

The seller pays Rs 16.25 crore, 65% of Rs 25 crore, and the buyer owes about Rs 5.56 lakh of accrued premium, so the net cash to the buyer is about Rs 16.19 crore. Protection covers face less recovery, and the auction fixed recovery at 35%. The premium accrues from the last coupon date to the credit event: Rs 25 crore times 2% times 40 over 360. The contract then ends; no further premium is due.

Think of fire insurance on a house: the insurer pays what was lost, not what the house was worth, and if the walls are still standing the payout is smaller. A credit default swap pays face less recovery, so with the auction at 35% the seller owes 65% of Rs 25 crore, Rs 16.25 crore. The auctionThe market-wide process that sets a single recovery price for the deliverable bonds of a defaulted company, used to cash-settle every CDS on that name. matters because it fixes one recovery for every contract on the name, so the buyer does not need to own or find bonds to deliver. Under physical settlement the buyer would hand over Rs 25 crore face of bonds and receive Rs 25 crore, which is the same economics once the bonds' 35% value is counted.

Premium accrues daily from the last coupon date and stops at the credit event. At 200 basis points on Rs 25 crore the annual premium is Rs 50 lakh, so 40 days on a 360-day year is Rs 5.56 lakh. That is paid by the buyer at settlement, usually netted, so the buyer receives Rs 16.25 crore less Rs 5.56 lakh, about Rs 16.19 crore. The contract terminates on the credit event, so the remaining coupons that would have been paid over the swap's life are simply never due; the buyer stops paying and the seller stops being paid.

Three things that separate a candidate who has seen a settlement from one who has read about it. The contract pays on the auction price even if the fund's own bonds trade differently, so a fund hedging a specific bond carries basis risk between that bond and the auction's cheapest deliverable. The day count and the exact accrual start, the last coupon date rather than the trade date, are contract terms and should be checked rather than assumed. And the seller's ability to pay Rs 16.25 crore is itself a credit risk; that is why these contracts are collateralised or cleared, and why the buyer's margin calls on the seller would have been rising as the spread widened in the weeks before the default.