Source: B&B Structured Finance Ltd |
In a cash-settled credit default swap, no bonds or loans are delivered. Instead, the protection seller simply pays the protection buyer an amount of money calculated as the notional value of the contract minus the recovery rate.
While most single name credit default swaps are physically settled, counterparties may agree to cash settle them instead. The recovery rate is based on a dealer poll, where the calculation agent obtains quotes from several firms that are active market makers in the reference obligation to determine its market value. For example, if the $10 million IBM contract were to be cash settled, the protection seller would pay the protection buyer $6 million, based on the 40% market value (recovery rate) of IBM’s reference obligation.