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For a qualifying credit event, a credit default swap (CDS) protection payment is generally calculated as outstanding notional × (1 − recovery rate). In an auction-settled contract, replace the recovery rate with the event’s Auction Final Price: notional × (100% − Auction Final Price). A USD 10 million CDS with a 35% final price therefore produces a gross protection payment of USD 6.5 million and represents USD 3.5 million of recovery value. The amount actually transferred can differ because the confirmation may require premium accrual, rebates, rounding, caps, floors and specific payment-date rules.
The two numbers that determine a CDS payout
A credit default swap has two economic sides. The protection buyer pays periodic premiums and receives compensation if the specified reference entity experiences a contractually defined credit event. The protection seller receives those premiums and makes the protection payment. CFA Institute defines a CDS as a contract in which one party buys protection against losses from a borrower’s default for a defined period.
For the protection leg, the essential inputs are:
- Outstanding CDS notional: the amount still covered when the credit event occurs.
- Recovery rate: the post-event value of the reference obligation expressed as a percentage of par.
- Loss given default (LGD): the fraction of par that was lost, calculated as
1 − recovery rate.
The basic gross calculation is:
Protection payment = Outstanding notional × LGD
Equivalently:
Protection payment = Outstanding notional × (1 − recovery rate)
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This is a protection-leg calculation, not necessarily the final net amount that one party pays the other after accrued premium and other contractual adjustments.
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How an auction price becomes the recovery rate
In an ISDA auction-settled CDS, the market does not normally rely on a guessed or generic recovery percentage. The auction establishes a final price for eligible obligations of the reference entity, quoted as a percentage of par. That price is used as the recovery rate for the cash settlement calculation.
ISDA auction language expresses the loss as “100% minus the Auction Final Price,” multiplied by the reference-entity notional. The corresponding recovery value is the Auction Final Price multiplied by notional, subject to any contractual caps or floors. If the final price is 35%, the loss fraction is 65%.
Auction prices are event-specific and can change substantially between issuers and credit events. Do not substitute a customary assumption such as 40% unless you clearly label it as a pre-auction valuation assumption. For an actual settlement, obtain the applicable event record from CreditFixings, the official source for event-specific auction cash-settlement values.
Worked calculation: USD 10 million notional at a 35% final price
| Input or result | Calculation | Amount |
|---|---|---|
| Outstanding CDS notional | Given | USD 10,000,000 |
| Auction Final Price / recovery rate | Given | 35% |
| Loss given default | 100% − 35% |
65% |
| Gross protection payment | USD 10,000,000 × 0.65 |
USD 6,500,000 |
| Recovery value represented by the reference obligation | USD 10,000,000 × 0.35 |
USD 3,500,000 |
The USD 6.5 million is the gross loss amount for the protection leg in this illustration. It assumes the full USD 10 million remains outstanding and excludes any accrued premium, rebate, rounding adjustment, or other amount required by the confirmation.
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What “recovery value” means
Recovery value is not a separate payment automatically added to the CDS payout. It is the value assigned to the reference obligation after the credit event, expressed as a percentage of par. In an auction settlement, a 35% final price means the obligation is valued at 35 cents per unit of par for the settlement calculation. On USD 10 million of covered notional, that represents USD 3.5 million of recovery value.
LGD is the complement of recovery. A 35% recovery rate produces 65% LGD; a 70% recovery rate produces 30% LGD. The two percentages must add to 100% when they describe the same notional and event.
The recovery percentage used for a live trade must come from the contract’s applicable settlement mechanism. The market price of one bond, a broker’s estimate, or a historical recovery rate may not be the correct input because eligibility, deliverability and auction rules determine the contractual price.
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- Identify the reference entity and transaction. Read the confirmation to verify the exact borrower, seniority, currency, notional, trade date, scheduled termination date and applicable ISDA Definitions version.
- Confirm that a contractual credit event occurred. Bankruptcy, failure to pay and restructuring can have different notice, evidence and settlement requirements. Use the determination date and event language specified in the confirmation rather than relying on a news report alone.
- Determine the remaining notional. Start with the original notional, then subtract any prior credit-event losses, scheduled amortization, partial terminations or index-loss allocations. A prior settlement may mean that only part of the original amount remains protected.
- Determine the settlement method. The confirmation may specify cash settlement, physical settlement or auction settlement. The method controls whether an obligation is delivered and how the recovery amount is established.
- Obtain the event-specific recovery input. For auction settlement, retrieve the official Auction Final Price for the correct reference entity, seniority and auction date. For another cash-settlement mechanism, use the price required by the confirmation. For physical settlement, identify the eligible deliverable obligation and the required delivery terms.
- Convert the price to LGD. If the final price is quoted as a percentage of par, calculate
LGD = 100% − final price. Convert the percentage to a decimal before multiplying. - Calculate the gross protection amount. Multiply remaining notional by LGD. Keep the currency and precision specified in the confirmation.
- Apply contractual adjustments. Check accrued premium, rebates, rounding, business-day conventions, payment dates, minimum transfer amounts and any caps or floors. These items can change the net amount or the date on which cash moves.
- Reconcile the settlement statement. Compare the calculation with the dealer, clearing service or calculation agent statement. Confirm that the event date, final price, notional and settlement currency all match the trade record.
Cash, physical and auction settlement compared
| Settlement method | What changes hands | How recovery is determined | Operational timing | Main exposure or issue |
|---|---|---|---|---|
| Cash settlement | The protection seller pays a calculated cash amount; the buyer does not deliver a bond under the cash leg. | A price or recovery value specified by the confirmation and applicable settlement rules. | Payment follows the notice, determination and payment-date rules in the contract. | The parties must use the correct valuation source, date, currency and calculation conventions. |
| Auction settlement | Cash is paid using the standardized auction result. | The ISDA auction determines an Auction Final Price for eligible obligations. | The auction and publication of the final price occur after the credit event and before cash payment. | The final price is event-specific; it should not be replaced with a generic recovery assumption. |
| Physical settlement | The buyer delivers an eligible deliverable obligation and receives the CDS notional, subject to the confirmation’s terms. | The delivered obligation and the contractual delivery amount determine the economics rather than a cash auction alone. | The buyer must give valid notice and deliver within the specified settlement window. | Deliverable-obligation eligibility, availability and cheapest-to-deliver economics can materially affect the result. |
ISDA describes auction settlement as replacing physical settlement with cash settlement using an auction-determined price. Physical settlement remains a different operational process: the buyer must source and deliver an eligible obligation, and the seller pays according to the contract’s delivery terms. A Smurfit protocol example describes requests to buy or sell deliverable obligations at the final price, illustrating why notice and deliverability language matters.
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How cash and auction settlement work in practice
Cash settlement without assuming a bond delivery
Under a cash leg, the buyer receives the calculated loss amount and keeps any reference obligation it already owns. The settlement calculation does not require the buyer to hand over a bond. The reference obligation’s value enters the calculation through the contractually specified final price.
For example, with USD 25 million of remaining notional and a 22% final price, LGD is 78% and the gross protection payment is USD 19.5 million. That figure still needs to be checked against premium accrual, rebate, rounding and payment-date provisions.
Auction settlement
An auction aggregates bids and offers for eligible obligations and publishes a final price used for the CDS cash settlement. The ISDA glossary describes this as cash settlement using the price determined by an auction. The correct record is the one for the relevant reference entity, obligation category and event; a price from another auction is not interchangeable.
Physical settlement
With physical settlement, the protection buyer tenders an eligible deliverable obligation and receives its contractual par amount from the seller. The confirmation defines which obligations qualify, the notice format, the delivery period, minimum denomination and other mechanics. If the buyer can choose among several eligible bonds, the relative market prices create cheapest-to-deliver exposure: the buyer may prefer to deliver the eligible obligation that is least expensive to acquire, subject to the contract and market availability.
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Premium accrual, rebates and the difference between gross and net payout
CDS premium is an annualized percentage of notional paid periodically. FpML identifies the CDS premium as an annualized percentage of notional. When a credit event occurs between scheduled premium dates, the trade may require an accrued-premium payment, a rebate, or both, depending on the confirmation and applicable protocol.
Therefore, distinguish these two calculations:
- Gross protection amount: notional multiplied by LGD.
- Net settlement amount: gross protection amount adjusted for the premium and rebate mechanics, rounding, fees if specified, and other contractual amounts.
Do not simply subtract a full quarterly premium from the protection payment. The correct accrual period, day-count convention, payment date and direction of any rebate come from the transaction documents.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.Estimating a payout before an auction
Before the Auction Final Price is known, you can produce a scenario estimate, not a confirmed settlement amount. Choose an explicitly stated recovery assumption and calculate the implied LGD. For instance, a 30% assumed recovery on USD 8 million of notional implies 70% LGD and a USD 5.6 million gross protection amount.
| Assumed recovery | Implied LGD | Gross payout on USD 8,000,000 notional |
|---|---|---|
| 20% | 80% | USD 6,400,000 |
| 30% | 70% | USD 5,600,000 |
| 40% | 60% | USD 4,800,000 |
| 50% | 50% | USD 4,000,000 |
These are sensitivity cases only. They do not establish what the auction will produce and should not be presented as observed recovery statistics.
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Contract details that can change the answer
Reference entity, seniority and deliverable obligations
Two CDS trades involving the same corporate group can settle differently if they reference different entities, debt seniorities or obligation categories. Confirm the legal name and the deliverable-obligation definition before using an auction record or bond price.
Credit-event type and determination date
Bankruptcy, failure to pay and restructuring may have different notice, grace-period and obligation provisions. The relevant date can affect premium accrual, auction eligibility and the payment timetable. A public announcement is not automatically the contractual determination date.
Outstanding rather than original notional
Use the notional remaining on the event date. Amortizing trades, prior partial settlements and index transactions can reduce the amount to which LGD applies. Multiplying the original notional after a prior loss allocation overstates the payout.
Caps, floors and rounding
ISDA language can impose contractual caps or floors on recovery or loss calculations, and confirmations specify rounding conventions. A spreadsheet that carries more decimal places than the settlement statement may differ by a small amount even when the inputs are correct.
Currency and payment date
Keep the notional and final price in the transaction currency. If another currency is used for funding or accounting, any conversion is a separate calculation governed by the relevant valuation date and FX convention. Business-day adjustments can move the actual payment date without changing the underlying loss percentage.
Common mistakes and how to correct them
- Using recovery instead of loss: Multiplying by 35% calculates recovery value, not the CDS loss. Use 65% LGD for the protection payment.
- Assuming every default recovers 40%: Recovery is event-specific. Replace the assumption with the official Auction Final Price when available.
- Using original notional: Reconcile prior settlements, amortization and index allocations before calculating.
- Confusing cash and physical settlement: A cash payout does not require bond delivery; physical settlement does.
- Ignoring deliverability: In physical settlement, verify that the obligation satisfies every eligibility condition and can be delivered in the required amount and period.
- Ignoring accrued premium: The gross protection amount may not equal the net amount shown on the settlement statement.
- Copying a historical auction price: Auction Final Prices are tied to a specific event and reference entity. Retrieve the applicable record instead.
- Rounding too early: Keep full precision through the multiplication and apply the contract’s rounding rule at the required stage.
A practical reconciliation checklist
- Reference entity and obligation category match the confirmation.
- Applicable ISDA Definitions version and settlement terms are identified.
- Credit event and determination date are confirmed under the contract.
- Remaining notional reflects every prior reduction.
- Settlement method is correctly identified as cash, auction or physical.
- Official event-specific final price or eligible delivered obligation is documented.
- LGD is calculated as 100% minus the recovery percentage.
- Currency, caps, floors, decimal precision and rounding agree with the confirmation.
- Premium accrual, rebate and payment-date rules are included in the net calculation.
- Settlement statement and independent calculation reconcile to the same inputs.
Formula reference
| Purpose | Formula |
|---|---|
| Loss given default | LGD = 1 − recovery rate |
| Gross protection payment | Notional × LGD |
| Auction-settled protection payment | Notional × (100% − Auction Final Price) |
| Recovery value | Notional × recovery rate |
| Auction recovery value | Notional × Auction Final Price |
| Net settlement | Gross protection amount ± accrued premium/rebate ± other contractual adjustments |
For a live trade, the confirmation and the applicable ISDA Definitions control if a simplified formula conflicts with a contractual provision. The calculation is only as reliable as the event determination, remaining notional and event-specific recovery input.
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