Credit Default Swap (CDS) Calculator
Calculation Results:
Annual Premium Payment: $0.00
Loss Given Default (if default occurs): $0.00
Expected Payout (Risk-Adjusted): $0.00
Understanding Credit Default Swaps (CDS)
A Credit Default Swap (CDS) is a financial derivative that allows an investor to "swap" or offset their credit risk with that of another investor. It acts like an insurance policy against the default of a specific debt instrument, such as a bond or loan. The buyer of the CDS makes regular payments (the premium or spread) to the seller. In return, the seller agrees to pay the buyer a lump sum if the underlying debt defaults.
Key Components of a CDS:
- Notional Amount: This is the face value of the underlying debt instrument (e.g., bond or loan) that the CDS contract covers. It represents the principal amount on which the premium payments and potential payout are calculated.
- Annual CDS Spread: Also known as the premium rate, this is the annual percentage of the notional amount that the protection buyer pays to the protection seller. It reflects the market's perception of the credit risk of the reference entity. A higher spread indicates higher perceived risk.
- Contract Tenor (Years): This refers to the duration or maturity of the CDS contract. It's the period over which the protection is provided and premium payments are made. Common tenors are 1, 3, 5, 7, and 10 years.
- Probability of Default (PD): This is the estimated likelihood that the reference entity (the borrower whose debt is being insured) will default on its obligations within the contract tenor. This probability is a critical input for assessing the risk and pricing of a CDS.
- Recovery Rate: In the event of a default, the recovery rate is the percentage of the notional amount that bondholders or lenders are expected to recover. This could be through liquidation of assets, restructuring, or other means. The actual loss incurred by the protection buyer (and paid by the seller) is the notional amount minus the recovered amount.
How the Calculator Works:
Our CDS calculator helps you understand the basic financial implications of a Credit Default Swap based on key parameters:
- Annual Premium Payment: This is the straightforward annual cost for the protection buyer. It's calculated as:
Notional Amount × (Annual CDS Spread / 100). - Loss Given Default (if default occurs): This represents the actual financial loss the protection buyer would face if a default happens, assuming no CDS. It's also the amount the protection seller would pay out. It's calculated as:
Notional Amount × (1 - (Recovery Rate / 100)). - Expected Payout (Risk-Adjusted): This metric provides a risk-adjusted expectation of the payout from the CDS seller. It considers both the potential loss if a default occurs and the probability of that default happening. It's calculated as:
Loss Given Default × (Probability of Default / 100). This value helps in assessing the fair value or expected cost/benefit of the swap over its tenor.
Example Scenario:
Imagine an investor holds a bond with a Notional Amount of $1,000,000. They want to protect against default for 5 years and find a CDS seller offering a Annual CDS Spread of 1.5%. The estimated Probability of Default for the bond issuer over 5 years is 10%, and the expected Recovery Rate in case of default is 40%.
- Annual Premium Payment: $1,000,000 × (1.5 / 100) = $15,000
- Loss Given Default: $1,000,000 × (1 – (40 / 100)) = $600,000
- Expected Payout: $600,000 × (10 / 100) = $60,000
This means the buyer pays $15,000 annually. If a default occurs, they expect to receive $600,000. The risk-adjusted expected payout from the seller is $60,000 over the contract tenor, reflecting the 10% chance of a $600,000 loss.