Settlement of CDS
Broadly, following are main ways of settlement of CDS.
(i) Physical Settlement – This is the traditional method of settlement. It involves the delivery of Bonds or debts of the reference entity by the buyer to the seller and seller pays the buyer the par value.
For example, as mentioned above suppose Danger Corp. defaults then SS Bank will pay
$ 10 Million to BB Corp. and BB Corp will deliver $10 Million face value of Bonds to SS Bank.
(ii) Cash Settlement- Under this arrangement seller pays the buyer the difference between par value and the market price of a debt (whatever may be the market value) of the reference entity. Continuing the above example suppose, the market value of Bonds is 30%, as market is of belief that bond holder will receive 30% of the money owed in case company goes into liquidation. Thus, the SS Bank shall pay BB Corp. $ 10 Million - $3 million (100% - 30%) = $ 7 Million.
To make Cash settlement even more transparent, the credit event auction was developed. Credit event auction set a price for all market participants that choose to cash settlement.
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