Question about CDS exercise

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Jones473

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Please see my questions below the answers with a –> in front of them.
EXAMPLE 2 - Settlement Preference
A French company files for bankruptcy, triggering various CDS contracts. It has two series of senior bonds outstanding: Bond A trades at 30% of par, and Bond B trades at 40% of par. Investor X owns €10 million of Bond A and owns €10 million of CDS protection. Investor Y owns €10 million of Bond B and owns €10 million of CDS protection.
  1. Determine the recovery rate for both CDS contracts.
  2. Explain whether Investor X would prefer to cash settle or physically settle her CDS contract or whether she is indifferent.
  3. Explain whether Investor Y would prefer to cash settle or physically settle his CDS contract or whether he is indifferent.
Solution to 1:
Bond A is the cheapest-to-deliver obligation, trading at 30% of par, so the recovery rate for both CDS contracts is 30%.
Solution to 2:
Investor X has no preference between settlement methods. She can cash settle for €7 million [(1 – 30%) × €10 million] and sell her bond for €3 million, for total proceeds of €10 million. Alternatively, she can physically deliver her entire €10 million face amount of bonds to the counterparty in exchange for €10 million in cash.
–> Alternative 1 gives total proceeds of 10. Alternative 2 seems also to give 10, but why is it not 7? I understand alternative 2 as the investor delivering her bond worth 30% to the protection seller, and receiving 100% in return, hence 70% in total.
Solution to 3:
Investor Y would prefer a cash settlement because he owns Bond B, which is worth more than the cheapest-to-deliver obligation. He will receive the same €7 million payout on his CDS contract, but can sell Bond B for €4 million, for total proceeds of €11 million. If he were to physically settle his contract, he would receive only €10 million, the face amount of his bond.
–> What does alternative 2 mean here, to physically settle. Does he deliver his bond worht 40% to the protection seller and receives 100%?
 
Could someone explain what happens in the two alternatives; physically settle and or cash?
 
OK. This is a thin topic and the LOS requires only to b) describe credit events and settlement protocols with respect to CDS. Nevertheless. The key to understanding the above is the following:
  • In a physical settlement the insurer (the CDS seller) buys the “bad” bond and gives the CDS buyer the face value.
  • The CDS buyer can sell any bond to the CDS seller as long they have the same seniority
Now think in terms of investor X and Y, who are the CDS buyers.
X can sell to the insurer the 3m bond A and receive 10m. Or she can say “just give me the difference of 7m”.
Y can instead sell his bond B for 4m and buy bond A for 3m in the open market, sell to the insurer this bond A and get back the face value according to contract. Cash flow is +4-3+10. You realize that Y now prefers physical settlement (i.e. exchanging actual bonds) rather than just settle for the difference of 6m. In the case of X there was no room for such manipulation.
Appreciate the fact that this is possible only because the contract specifies that both bonds are equal in terms of seniority. This is significant because during the company liquidation process the pecking order is ranked by bond seniority. Why does bond B trade higher than bond A then if the only variable now is seniority? Any comments will be welcome.
 
krokodilizm wrote:
OK. This is a thin topic and the LOS requires only to b) describe credit events and settlement protocols with respect to CDS. Nevertheless. The key to understanding the above is the following:
  • In a physical settlement the insurer (the CDS seller) buys the “bad” bond and gives the CDS buyer the face value.
  • The CDS buyer can sell any bond to the CDS seller as long they have the same seniority
Now think in terms of investor X and Y, who are the CDS buyers.
X can sell to the insurer the 3m bond A and receive 10m. Or she can say “just give me the difference of 7m”.
Y can instead sell his bond B for 4m and buy bond A for 3m in the open market, sell to the insurer this bond A and get back the face value according to contract. Cash flow is +4-3+10. You realize that Y now prefers physical settlement (i.e. exchanging actual bonds) rather than just settle for the difference of 6m. In the case of X there was no room for such manipulation.
Click to expand...
Thanks I appreciate your insights, but I still do not feel they answer my questions completely especially regarding investor X. It seems to me you write that she will have a total cashflow of 7, but in the answer it seems to be 10:
Investor X has no preference between settlement methods. She can cash settle for €7 million [(1 – 30%) × €10 million] and sell her bond for €3 million, for total proceeds of €10 million. Alternatively, she can physically deliver her entire €10 million face amount of bonds to the counterparty in exchange for €10 million in cash.
–> Alternative 1 gives total proceeds of 10. Alternative 2 seems also to give 10, but why is it not 7? I understand alternative 2 as the investor delivering her bond worth 30% to the protection seller, and receiving 100% in return, hence 70% in total.
 
krokodilizm wrote:She receives 7m but she also owns a bond worth 3m which she can sell
Click to expand...
Yes in the second case she gets the difference, seels the bond and has total proceeds of 10.
However you write: “X can sell to the insurer the 3m bond A and receive 10m. ” In this case she will only be left with 7 how I understand it?
 
She receives a cash flow of 10m, why do you say she is left with 7m? Look at two scenarios for X in terms of cash flows
Scenario 1 - Physical settlement
She owns a bond with market value of 3m. She can sell it in the open market and receive 3m, but because she has an”insurance contract” she can throw it to the seller and receive 10m. She actually gave the bond worth 3m and received a bank transfer of 10m. In her balance sheet she has a value of 10m.
Scenario 2 - Cash settlement
Her balance sheet value is 3m and she triggers her CDS cotract and asks the seller to transfer her 7m so as she is covered up to 10m. Her balance sheet is equal to scenario 1 but there was no transfer of bond.
Now look at investor Y.
His balance sheet value currently is 4m. He has a contract that has him covered up to 10m. So he can ask the seller to transfer him 6m. This would be cash settlement. However, if he is smart, he can choose physical settlement, i.e. give him the bond and get 10m full. But here is a catch; he will not give him the bond that is worth 4m. He will instead sell it in the open market, get 4m, buy the other bond worth 3m and give the seller the cheaper bond. So he will receive his 10m but in the meantime he also earned 1m in the open market.
 
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