Credit Default Swap Settlement and Recovery Conventions
Summary
The document compares physical settlement, auction-based cash settlement, and fixed-recovery cash settlement for credit default swaps. Under physical settlement, the protection buyer delivers an eligible debt obligation and receives its face amount. Auction settlement instead uses a post-credit-event auction to establish a floating recovery value, and the protection seller pays the notional less that recovery. Fixed-recovery contracts set the recovery assumption when the swap begins, so the payment after a credit event is based on that agreed value.
The answer notes that auction settlement is the common cash-settlement approach, while fixed recovery is less common and may use different agreed recovery levels. It also describes combining fixed-recovery and standard CDS positions to express a view on realized recovery. Marking a fixed-recovery contract using standard CDS quotes can make its value more sensitive to the recovery assumption. The document offers a conceptual comparison, without detailing valuation formulas, auction mechanics, or contract-specific terms.
Key ideas
- Physical settlement exchanges an eligible debt obligation for its notional face amount after a credit event.
- Auction cash settlement uses a post-event market process to determine recovery and calculate the protection payment.
- Fixed-recovery CDS contracts specify the recovery value at inception.
- Combining fixed-recovery and standard CDS positions can express a view on realized recovery.
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Full text
# <Credit Default Swap> Auction Recovery vs Fixed Recovery # <Credit Default Swap> Auction Recovery vs Fixed Recovery What is the Difference between Auction Recovery CDS and Fixed Recovery CDS? ## Answer by Dimitri Vulis (score 3, accepted) https://quant.stackexchange.com/a/48722 How is the CDS settled if the credit event happens? Physical settlement (used to be prevalent in the early days, the 1990s) means that the protection buyer gives the protection seller the reference obligation (or another debt security pari passou with the ref ob), and the protection seller pays the protection buyer the notional face value. (similar to exercising a put.) It is not necessary to figure out what the defaulted debt is worth under physical delivery. Cash settlement with floating (auction) recovery (by far the most common these days) means that an auction is held soon after the credit event that determines how much the defaulted ref ob is worth. The protection seller than pays to the protection buyers the notional minus the floating recovery from the auction. Cash settlement with fixed recovery (much less common than floating recovery) means that the buyer and the seller agree at the inception of the swap what price to use for the defaulted ref ob. The protection seller than pays to the protection buyer the notional minus the fixed recovery. The fixed recovery is usually 0 (i.e. the protection seller pays the full notional to the buyer), but I've seen contract with 40% fixed recovery as well. One can combine a fixed-recovery CDS with a vanilla CDS to take a view on what the recovery would actually be. It is easy to see that if you mark to market a fixed-recovery CDS using vanilla CDS quotes (which are much easier to observe in the market) then the mtm has much higher sensitivity to the recovery assumption than the MTM of vanilla CDS.
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