Credit Default Swaps

[Caramel]

From my reading of Chapt. 21 (Options, Futures & Other Derivatives), p.508 indicates that there are two settlement method when default takes place: 1) pysical settlement and 2) cash settlement.

It appears to me that one should opt for a physical settlement if wish to insure the entire face value of the defaulted bond, as with the cash settlement, one does not receive the entire face value of the defaulted bond, but the (face value - mid market value of the cheapest deliverable bond).

So, if Credit Default Swaps with physical settlement provides more credit protection, it also means they must be priced higher than credit default swaps with cash settlement?

Any feedbacks are appreciated. Thanks!

[Laurelinda]

My reading is that as far as value is concerned, they should be theoretically equivalent.

If you have a cash settlement, the bond holder and buyer of credit protection gets paid (face value - mid market value of the bond) and can theoretically get rid of the bond by selling it in the market, thus recovering the rest of the face value.

If you have a physical settlement, the bond holder and buyer of credit protection gets paid the entire face value of the bond in return for the bond itself. This puts the buyer in the same ultimate position as above, but the credit protection seller is out the extra amount of money equal to the mid market value of the bond. The seller can then recover this amount by selling the transferred bond in the market.

Either way, the buyer of credit protection is sure of being able to replace the devalued bond with its face value.

That said...I think the inefficiency of having to dispose of the bond in the market probably introduces some extra risk in practicality, so from that standpoint a physical settlement may be quoted higher. :shrug:

[yueZHAO]

I agree to Laurelinda. wether settle by cash or physical, it depends on the buyer's preference.