In this workout, we are looking at a real disaster scenario. Alpha has bought a two-year CDS from Beta on a notional amount of a 100 on the three-year bonds issued by Charlie. The CDS has an annual premium of 105 basis points and cash settlement. There is a credit event just before the end of the second year, and the underlying Charlie bonds become practically worthless. Beta, the CDS writer or the seller of the CDS, defaults on the payout. Oh, no. What is the effect to Alpha? Well, of course, Alpha still has to pay the full CDS premium for the term here, and the term is two years. The premium is 1.05 and the notional is 100. So all in, the premium paid out by Alpha is two years times the annual premium times the notional. So 2.1 paid out.

But it looks like Alpha made the right bet here because Charlie defaulted and the bonds are worthless. So they had insured 100 worth of notional, there was zero remaining value of the bonds, so they would've expected to receive 100 here on the payout on the CDS. That would've made their net cash flows, of course, the 100 received minus the 2.1 paid out. So they'd have expect to have a net cash inflow here of 97.9. It would've been absolutely party time here. But of course, what happens is that, yes, they had a default here of 100 and the remaining value of the bonds would've been zero, just like before, but because Beta is not paying, they're actually still receiving zero on the CDS here. So their net cash flows is just going to be whatever they had paid out over the life of this trade, which was 2.1. So instead of making 97.9 here, they made a loss of 2.1. This is a true disaster and it highlights the double credit risk of a CDS. Alpha took the right bet in the market here and they would've made an absolute killing but they traded with a weak counterpart. The solution, of course, would've been to do business with stronger counterparties, or, which is of course much more common, to have counterparties continuously post collateral to you on existing traits.