Recovery swaps are a type of credit derivative that has seen sporadic bouts of trading since the instrument was first introduced in 2003. The product allows users to express views on recovery rates upon default.
In a recovery swap two counterparties agree, in effect, to swap recovery rates following a credit event. In the case of a physically settled recovery swap the recovery buyer agrees to buy defaulted bonds from the recovery seller at the ‘strike’ rate – say, 40%. The recovery buyer is fixing the price at which it buys the defaulted bonds and is therefore long recovery rates, because it will benefit if the actual recovery rate is higher than the strike rate. The recovery seller wants the real recovery rate to be lower than 40% and is therefore short recovery rates.
No premium changes hands during the life of the trade, and recovery swaps are quoted in terms of the strike price. A dealer might quote recovery swaps in Ford (see article above) at 55/60. This means it is prepared to sell a recovery swap at 60% and buy at 55%.
This method of trading a recovery swap, which is sometimes called a recovery lock, takes a conventional credit default swap but with the premium set at zero and the reference price set at the strike rate (rather than 100%).
Alternatively, though less commonly, recovery swap can be traded as two back-to-back credit default swaps, one with a fixed recovery rate and the other using normal a floating recovery. If the fixed recovery rate is the current market assumption of recovery rates on the name, then there is no exchange of credit default swap premium in the recovery swap. If, however, the fixed recovery rate is different from the current market recovery assumption, there is an exchange of premium equal to the difference between the premium on the fixed recovery swap and the premium on the market standard credit default swap.
Recovery swaps tend to be traded when a company is nearing default and trading tends to be driven by dealers’ need to hedge their books. Most recovery trades in this situation take the form of the recovery lock, since market participants look to isolate and trade the recovery of a credit without paying any credit default swap premium.
Credit derivative market makers need to make assumptions about the recovery rates of the different credits they trade – for example, when offering an unwind. For investment grade credits, most banks use an assumption of 40% . If these assumptions turn out to be wrong, the dealer could gain or lose money in the event of a default.