How Recovery Swaps Hedge Uncertain Default Recoveries

Summary

The document explains the difference between credit default swaps and recovery swaps in the context of loan default risk. A CDS provides protection when a defined credit event occurs, such as a borrower’s failure to make a coupon payment. The protection addresses the loss associated with default, subject to the contract’s terms.

A recovery swap targets uncertainty in the value ultimately recovered after default. Creditors may have claims on the borrower’s assets, but those assets may be worth less than the debt, and their value can remain uncertain between default and the recovery payout. A recovery swap or recovery default swap can hedge that recovery-value exposure. The explanation is qualitative and brief: it does not specify contract settlement conventions, pricing, or how a recovery swap’s payoff is calculated, so those details require further reference before applying the distinction to a transaction.

Key ideas

• A credit default swap provides protection triggered by a defined credit event.
• A borrower’s asset value may be insufficient to repay its outstanding debt after default.
• A recovery swap hedges uncertainty in the amount recovered following default.
• The distinction concerns default protection versus exposure to the eventual recovery value.

Tags

# What is the difference between a recovery swap and a CDS?


# What is the difference between a recovery swap and a CDS?












As I understand it, recovery swaps and CDS are both used to provide hedging against the default risk of a loan.

What is the difference between them?

## Answer by ash (score 4, accepted)

https://quant.stackexchange.com/a/8105

CDS provides protection against default. So when a firm is unable to pay the coupon (and there are few more scenarios where firms default) CDS is triggered.

After default the liability holders have first claim on the firm's assets. If the assets are less than loan (say 60% of loan amount) then recovery can only be 60%.

if these are risky assets and there is possible uncertainty in the asset value from the time of default to recovery payout one can buy recovery swap or recovery default swap to provide a hedge against the such uncertainty of recovery in default.

Hope that makes sense

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.