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Subject 2. Credit Events and Settlement Protocols PDF Download
Credit Events

The CDS pays off upon occurrence of a credit event. The selection of credit events is subject to negotiation, and should be defined clearly in the CDS terms.

There are three general types of credit events:

  • Bankruptcy. The reference entity has filed for relief under bankruptcy law.
  • Failure to pay. The reference entity fails to make interest or principal payments when due.
  • Restructuring. The configuration of debt obligations is changed in such a way that the credit holder is unfavorably affected.

Settlement Protocols

Settlement methods:

  • Physical settlement. The reference asset is delivered to the protection seller in exchange for the face value of the paper in cash.
  • Cash settlement. A cash payment made from the protection seller to the protection buyer is the difference between the market price and the face value of the debt.

    • Recovery rate: the % of loss that is recovered.
    • Payout ratio = 1 - Recovery rate (%)
    • Payout amount = Payout ratio x Notional

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