You might be thinking, how can a standardized coupon be used when both sides of the trade will have agreed to a market level of the CDS spread, which makes the trade have a zero PV on day one? The agreed market price is highly unlikely to be exactly 100 or 500 basis points per year, so isn't one side of the trade going to lose out? The answer to this is that when a standard coupon is agreed, a one off upfront cashflow is also paid on the CDS, which equates to the value change between the market spread and the coupon chosen.

The upfront calculation uses the pvo one of the swap to calculate the present value of the difference between the market CDS spread and the agreed coupon.

For example, if a trade is agreed at a spread of 250 basis points per year and both sides agree to clear the trade using the 100 basis points standard coupon, then the buyer who is now benefiting from paying 150 basis points per year less than the agreed spread will pay the present value of that difference upfront to the seller.

To put some numbers to this, if the pvo one of the swap is four and the notional is $10 million, then the buyer would pay one and a half percent times four times 10 million to the seller, that is $600,000.

The trade would then forevermore be a CDS with a 100 basis points coupon.

To compute the pvo one.

Practitioners use the standard ISDA model that works on certain simplifying assumptions.

For example, it uses fixed recovery rates of 40% for senior debt and 20% for junior debt.

It also assumes a flat CDS curve as well as an upfront payment covering the change in coupon.

Accrued interest is also exchanged just like in a bond transaction.

This is because standardized contracts have fixed maturity dates, not fixed maturity lengths, and always pay a full first coupon.

So the seller of the CDS will pay accrued interest to the buyer reflecting the partial accrual of coupon in a short first period.

For example, if we trade the on the run five year with the 20th December maturity date and quarterly rolls, coupons will be paid on the 20th of March, June, September, and December.

If we sell this contract for settlement on 7th of November, we will be entitled to the full first coupon from September To December, and consequently, we will pay the portion of coupon which has accrued from 20th of September to 7th of November as accrued interest when the trade is settled.