Cash settlement in CDS:
Physical settlement – This is the most widely used settlement method in which protection buyer delivers the notional amount of the deliverable obligations of the reference entity to the protection seller in return for the notional amount paid in cash. There are many deliverables obligations, which buyers of the protection can choose amongst. Generally, these options include restrictions on the maturity and the requirement that they are pari passu – most CDS are linked to senior unsecured debt.
Pari passu (investopedia definition)- A Latin phrase meaning “equal footing” that describes situations where two or more assets, securities, creditors or obligations are equally managed without any display of preference.
Cash settlement: It is an alternative method of physical settlement and is not that frequent is CDS system but is overwhelmingly used in case of CDOs (‘Collateralized Debt Obligation). In cash settlement cash is made by the protection seller to the protection buyer which equals to par minus the recovery rate of the reference assets. Market analysis and other dealers quotes are needed to calculate the recovery rate.
Suppose a protection buyer purchases a 5 years contract at a spread of 500bp. The face value of protection is $20m. Then the protection buyer has to pay ($20m X .05 X 0.25) = $250000 – ignoring calendar days and day counts. Let’s say after a short duration reference entity faces credit event, which forces for recovery rate calculation, say it is $45 per $100 of face value.
Now protection seller has to compensate the protection buyer for the loss on the face value of the asset received, which will be $11m in this case.
In addition, protection buyer has to pay the premium payment for the period until credit event. In this since credit event occurred within a month time, protection buyer has to pay ($20m X 500bp X 1/12) = $ 83333.33.
There are upfront – CDS as well when protection buyer pays a lump sum amount in the beginning to some specified maturity, there are no more payments required during the period unless a credit event and the cash settlement is processed through standard CDS.
Liquidity in differs from cash credit market in a number of ways. In terms of maturity, the most liquidity CDS market is 5 years contract followed by 3years, 7 years, and 10 years.
Basket Default Swaps:
It is about redistributing the credit risk across a number of different securities. The portfolio can be small as 5 or large as 200 or more credits. Here the redistribution is based on the idea of assigning losses to different securities in a specified priority with some being first and others taking later losses. It is obvious from the notion that it might expose the investors to default together. This points to default correlations, the simplest correlation product is the basket default swap.
A basket default swap is similar to CDS, the difference being that the trigger is the nth credit event in a specialized basket of the reference entities. Generally, basket contains 5 to 10 reference entities. FTD (First to default) basket, n=1, and it is the first credit in a basket of reference credits in a basket of reference credit whose default triggers a payment to the protection buyer. As with a CDS, the contingent payment typically involves physical delivery of the defaulted asset in return for a payment of the par amount in cash. In return for assuming the nth-to-default risk, the protection seller receives a spread paid on the notional of the position as a series of regular cash flows until maturity or the nth credit event, whichever is sooner.
The most that the protect buyer can lose is the par – recovery value of the FTD asset on the face value of the basket.