Now that we have dealt with the cashflow mechanics, let's have a look at what drives the payment of the default leg.

If you have a contract which pays out on a so-called credit event, then it is clearly important to define what that means so that there is no ambiguity as to whether or not it has happened.

The most obvious credit events are where the reference entity is declared bankrupt or has failed to make a payment and is therefore in default.

Less obvious is when the underlying debt is restructured, where the characteristics of the debt are changed in a way which negatively impacts creditors.

For example, the coupon is reduced.

CDS can pay out on restructuring, but it is important to check the language in the contract because not all include it as a credit event.

Other credit events include repudiation where the debtor refuses to recognize the existence of the debt and moratorium where pause is taken in debt.

Repayment. CDS trading is generally done under an ISDA agreement, and as such certain standardized terms will be agreed.

When ISDA believe a credit event may have happened, they convene a determination committee who then pronounce as to whether CDS default legs should pay out.