In this workout, we explore what happens to a CDS contract when the underlying credit experiences a credit deterioration.

So in this case, Alpha buys a two-year CDS from Beta on a notional amount of 100 on the three-year bonds issued by Charlie. The CDS is an annual premium of 105 basis points and cash settlement. Just after the original trade, Charlie experiences trading difficulties. So Charlie is seeing a deterioration in his own credit here. The CDS spread goes up by 50 basis points to reflect this. Alpha unwinds the CDS trade. What will be the net cash flows over the CDS term for Alpha? So first of all, we look at the original CDS. It was a two-year CDS. The premium was 105 basis points and the notional was 100. So overall, over the life of this trade, Alpha has to pay out 1.05%, two years times the notional amount. So they have to pay 2.1.

However, as they close out the CDS, they are facing different credit conditions. They're closing out immediately with two years to go. The notional is still 100, but now they're going short the CDS, and all of a sudden the CDS is trading at 155 basis points because it's expanded by 50 basis points. So now all of a sudden, they will receive 1.55%. So the premium that they receive in total, of course, is going to be that 1.55% for the duration of two years times the notional amount of 100. So they'll receive 3.1 over the term of this trade. So of course, the net cashflow here to Alpha will be one, which is a cool profit for Alpha to be making on this CDS position, so they have successfully speculated here in the credit deterioration of the underlying credit.