1. Credit Default Swap Protection Buyer premium (say 40 bps) Protection
Seller
if reference entity defaults
pays par value of defaulted
debt
Reference
Entity

2. Credit Default Swap Protection Buyer premium (say 40 bps) Protection
Seller
if reference entity defaults
pays par value of defaulted
debt
Physical Settlement: protection buyer sells defaulted assets to protection seller
for par value.
Cash Settlement: counterparties poll market to determine recovery value of
defaulted assets; then protection seller pays the difference between par and
recovery value to protection buyer

3. Valuation – Floating Rate Reference Asset
Protection
Buyer
premium (say 40 bps)
Protection
Seller A B
if reference entity defaults
pays par value of defaulted
debt
LIBOR + spread
A’s rate with the swap: LIBOR + spread - premium
Risk-free rate: LIBOR
Therefore: premium = spread
Reference
Asset