Fixed Coupons and Upfront Payments in CDS Contracts

For practical reasons, the coupon on CDS contracts within the same series usually remains fixed for new trades, even though the market spread changes over time. As a result, when a new buyer and seller enter into a contract, the mark-to-market difference is settled through an upfront payment. In other words, the difference between the contractual coupon and the current market spread must be compensated.

A new contract could instead be written with a newly determined coupon rate. However, because a standardized coupon makes contracts easier to compare, trade, net, and clear, the upfront-payment mechanism has proved more convenient.

Suppose that:

• fixed coupon = 100 bps
• current market spread = 70 bps

The protection buyer will therefore pay 30 bps more than the fair market rate in the future. Accordingly, the protection seller makes a one-time upfront payment to the buyer at the beginning of the contract.

Conversely, if the market spread is 130 bps, the buyer will pay a coupon below the fair market rate. In that case, the buyer makes the upfront payment to the seller.

Conceptually, the upfront payment represents the present value of the difference between the future coupon payments, adjusted for risk. The upfront payment is made only once, while the fixed coupon is paid periodically, usually quarterly.

For example, suppose that:

• the risk-free rate is approximately 3%–4%
• the investment-grade CDS spread is approximately 50 bps
• the recovery rate is 40%

The hazard rate would then be approximately:

[
lambda approx frac{0.50%}{1-40%}=0.83%
]

Accordingly, a combined implied rate might be approximately 4%–5%.

For a high-yield CDS, default risk is higher, so the implied rate may be approximately 8%–10%, or even higher.

CDS type	Approximate implied rate
Investment grade	Approximately 4%–5%
High yield	Approximately 8%–10%
Distressed credit	Potentially much higher

This implied rate is not normally quoted separately in the market. It is included here only as a useful way of interpreting the valuation.

For an investment-grade CDS, the effective discount rate applied to the future spread difference is generally close to the risk-free rate, but slightly higher because of survival risk.

Adapted from:

John C. Hull, Options, Futures, and Other Derivatives, Chapter 24 — Credit Derivatives.