In relation to a default swap (a credit default swap/ CDS), it is one of the two legs of the swap- i.e., the payment that would be made by the protection seller if a credit event occurs before the maturity date of the swap (the other leg is known as a premium leg). This payment equals the difference between the par value of the protection and the price of the cheapest to deliver (CTD) asset of the reference entity on the par value of the protection.

The protection leg is a contingent payment of actual losses (100% – expected recovery rate) on the par value of the protection triggered by the credit event:

Protection leg = 100% – R

The expected recovery rate “R” is, the expected price of the CTD asset/ obligation into the protection once a credit event takes place. This payment is meant to compensate the protection buyer for any losses associated with or arising from the credit event.

The protection payment can be cash or physically settled as defined in the contract.