Joint Defaults and Protection Choices in First-to-Default CDS
Summary
The document examines how simultaneous or clustered credit events affect the payoff mechanics of a first-to-default credit default swap. Based on an informal reading of nth-to-default term sheets, the answer suggests that when adjacent ranked defaults occur together, the protection buyer may be able to choose which reference credit event to claim against and whether to deliver an eligible defaulted obligation or settle in cash using an auction amount. The buyer would favor the alternative that is more advantageous under the contract terms.
The answer also suggests that a buyer might wait after an earlier default and later notify the seller about a subsequent event, while continuing to pay premium until the selected event. These are tentative interpretations, not legal conclusions, and the author explicitly acknowledges uncertainty about the documentation. The discussion does not rigorously explain how correlation changes valuation; it instead highlights that notice, settlement, and timing provisions can determine the payoff mechanics that a pricing model must represent.
Key ideas
- First-to-default CDS settlement choices are governed by the contract's notice and delivery terms.
- For simultaneous ranked defaults, the protection buyer may have a choice among eligible events and settlement alternatives.
- The buyer may be able to wait for a later event, subject to the contract's premium and notice provisions.
- The interpretation is tentative and does not provide a formal account of correlation's pricing effect.
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# First-to-Default Credit Swap: what is the payoff when a joint default occurs # First-to-Default Credit Swap: what is the payoff when a joint default occurs I keep reading about the impact of default correlation on the pricing of a First-to-Default (FtD) credit default swap (CDS). What no one explains is how a joint default event impacts the actual payoff of the FtD CDS. If we assume that it is impossible that more than one names can default at exactly the same time then I cannot see how default correlation matters. If on the other hand the probability of joint default is not zero, then it can only impact the valuation if upon a joint default of two or more names the payoff somehow changes (perhaps the term sheet specifies that the worst credit is redeemed). But in none of the books, papers and other treatises has anyone deemed appropriate to explain what actually happens when a joint default occurs. Now is the time for someone to do this... ## Answer by Dimitri Vulis (score 1, accepted) https://quant.stackexchange.com/a/66257 I am not a lawyer. I do have some old $n$th to default term sheets just lying around. Reading them, I interpret their language to work very similarly to the cheapest-to-delver language in single-name CDS. To emphasize again this is just my understanding of some complex legalese and I could well be missing something. Recall that with the single-name CDS, after the credit event, the protection buyer can either physically deliver one of the obligations pari passu with the reference obligation; or pay cash amount determined at the auction. Natually, the protection buyer will choose whichever is the cheapest for him. My interpretation of the term sheets is that if the $n$th and the $n+1$st credit events happen similtaneously, then the protection buyer can either physically deliver one of the obligations pari passu with either the $n$th or the $n+1$st reference obligation; or pay cash amount determined at either $n$th or the $n+1$st auction. Again, we can expect the the protection buyer to choose the cheapest. The protection buyer chooses which event to serve notice on, and which physical defaulted obligation, or cash to deliver. Further, if only the $n$th event occurs, then the protection buyer can still choose to wait for the $n+1$st (or $n+2$nd etc) event to occur, and then serve notice on the protection seller for the $n+1$st event (or $n+2$nd etc). I don't see that the buyer is obligated to serve notice on the $n$th event and is not allowed to wait for a more favorable event. However, sorry, I'm not sure how this connects to default correlation. Suppose, as an extreme example, that you buy first to default ptotection on UMS sovereign and PEMEX and CFELEC (quasi's). Suppose than one of the quasis defaults Monday and another quasi defaults Wednesday, and finally the sovereign defaults Friday. You'd choose which notice to deliver based on your belief who has lower recovery, which would probably be one of the quasis. But if the sovereign never defaults, only the quasis do, then you'd still collect on the defaulted quasi of your choice (paying premium until the day of the event you choose to serve notice for).
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.