Physical settlement

A payout following a credit event in which the protection buyer delivers an eligible obligation (a deliverable obligation) to the protection seller in exchange for the par value of the asset. Physical is the standard form of settlement for most credit derivatives.

Credit default swap contracts define the ‘deliverable obligations' - that is, which of the issuer's bonds or loans can be delivered by the protection buyer following a credit event. This ‘pool of deliverables' is usually defined as bonds or loans issued by the reference entity that are not subordinated to the reference obligation. However, certain types of debt instruments - such as those denominated in minor currencies, those that are not fully transferable, and those whose payment is contingent on particular circumstances - are usually excluded from this pool and may not be delivered.

In a standard credit default swap, the pool of deliverables includes all the entity's conventional senior debt (bonds and loans, secured and unsecured), but it excludes subordinated (junior) debt, preference shares, trade debts and obligations with certain non-standard features.

The reference obligation is simply a specific bond or loan issued by the reference entity which is agreed to at the start of the trade in order to ‘characterise' the deliverable obligations.

If the protection buyer can access more than one deliverable obligation, it has the option of delivering the cheapest one available. Thus the protection buyer owns a cheapest-to-deliver option, which is one of the main reasons that credit default swap spreads are usually wider than bond spreads for the same reference entity.

Physical settlement has the advantage that it is not subject to manipulation by either party. But it has some severe drawbacks (for more information, see the 'essentials' guide online). As a result, many credit derivatives are cash-settled.

See also cash settlement.