The standard form of settlement for credit derivatives at the time of publication is physical settlement. After the protection buyer has triggered a credit event, with the delivery of a ‘notice of physical settlement’, the protection buyer delivers to the protection seller bonds or loans (‘deliverable obligations’) with a notional amount identical to the notional amount of the credit default swap. The protection seller then pays the protection buyer the notional amount of the credit default swap.
For example, for a standard $10 million contract on IBM, when IBM defaults, the protection buyer delivers defaulted bonds with a $10 million face value and receives $10 million from the protection seller. If the defaulted bonds are worth $4 million (40% of their face value, where 40% is called the recovery rate), the protection buyer has effectively made $6 million as a result of buying protection. The seller of protection could choose to sell the defaulted bonds, so achieving their recovery value.
Source: B&B Structured Finance Ltd |
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 (see page 75). As a result, many credit derivatives are cash-settled.