A fund buys five-year protection on Rs 50 crore of Jharsa Minerals bonds. The market spread is 350 bp, the standard running coupon 100 bp and the risky annuity 4.2. What is paid upfront, what is paid each quarter, and who pays whom?

The buyer pays Rs 5.25 crore upfront to the seller, then Rs 12.5 lakh every quarter. The upfront is the market spread less the coupon, 250 bp, times the risky annuity of 4.2, which is 10.5% of Rs 50 crore. The quarterly coupon is 100 bp a year on Rs 50 crore divided by four. Both flows run from buyer to seller; the seller pays only if Jharsa defaults.

Think of a rented flat with a fixed rent set years ago. If the market rent today is higher, a new tenant taking over the lease pays the landlord a lump sum for the right to keep paying the old rent. A standard CDS works the same way: every contract on Jharsa pays the same 100 bp coupon so that contracts are interchangeable and can be netted, and the difference between that coupon and the 350 bp the risk is actually worth is settled as a lump sum at the start. The market still talks in spread, 350 bp, because that is the price of the risk; the coupon is a plumbing convention, and the upfront is what reconciles the two.

The shortfall is 350 less 100, 250 bp a year for five years, but only while Jharsa has not defaulted. The risky annuityThe present value of receiving one unit a year for the life of the contract, counting only the years the name survives and discounting them. Here 4.2 for five years. of 4.2 turns that stream into a present value: 250 bp times 4.2 is 1050 bp, 10.5% of notional, Rs 5.25 crore on Rs 50 crore. The buyer pays it to the seller, because the buyer is the one who will underpay for five years. Note that the annuity is 4.2, not 5: a year of coupon is worth less than one both because it is discounted and because the name may have defaulted before it is due.

The running coupon is 100 bp a year on Rs 50 crore, Rs 50 lakh a year, paid quarterly, so Rs 12.5 lakh at the end of each quarter from buyer to seller. In return the seller owes nothing unless Jharsa suffers a credit event, at which point the seller pays Rs 50 crore less the recovery value of the bonds, and the coupons stop. Over a full five years with no default the buyer will have paid Rs 5.25 crore plus twenty coupons totalling Rs 2 crore, about Rs 7.75 crore in all, undiscounted, for the protection. That is close to 350 bp a year on Rs 50 crore, Rs 1.75 crore a year, which is the sense check: the plumbing changes the timing of the payments, not their value.

State the limits. The risky annuity of 4.2 is a model output that depends on the assumed recovery and the hazard rate implied by the spread itself, so a different recovery assumption gives a slightly different upfront. The convention also includes an accrued-coupon adjustment on the trade date and the exact day count on each quarter; confirm both on the ticket rather than from memory. And the fund now has counterparty exposure to the dealer equal to the value of the protection, which rises exactly when Jharsa deteriorates, so the trade belongs under a collateral agreement.