Delivery of Defaulted Debt in CDS

[brian.field]

Let's assume a company issues $100 in bonds. Also, let's assume that there are CDS contracts in place with a notional amount of $1000, i.e., more contractual notionals than actual bonds (which is not uncommon.)
Assume also that none of the parties that purchased protection in the above scenario actually own the bond referenced in the CDS. Now, assume that issuing company defaults.

If each protection buyer attempts to deliver the reference bond to their corresponding protection seller, there simply won't be enough bonds to deliver.

How is this handled? (Assume that there are no other bonds from which to provide sufficient delivery.)

There are a number of interesting scenarios that could unfold from the above.....

 

[ShaktiRathore]

Hi brian
I think there might not be physical settlement of bond but only the difference b/w mkt value and face value shall be delivered.
Thanks

 

[brian.field]

Ahhh....that would make a lot of sense. Thank you.

Brian

 

[brian.field]

Malz seems to imply physcal delivery but he may just be simplifying the details for illustrative purposes only.

On page 248, he states, " In the event of default, the contract obliges the protection seller to pay the protection buyer the par amount of a deliverable bond of the reference entity; the protection buyer delivers the bond. The CDS contract specifies which of the reference entity’s bonds are “deliverable,” that is, are covered by the CDS."

My scenario applies the constraint that no other deliverable bond is available.

 

[ShaktiRathore]

Yes Malz is talking physical settlement,in case no other deliverable bonds are their, and no option of mark to market settlement your scenario seems sensible but such contract seems illogical because if there are no bonds for physical settlement how can one specify it in the contract ,if bonds are not available mark to cash settlement seems last viable option to honour the contract.
Thanks

 

[brian.field]

I agree....but I was also thinking about a company that sells protection buying up all or most of the available bonds to deliver which would allow them to corner the market and drive up bids.

Brian