Purchaser of Protection in CDS

[brian.field]

Culp states that if a protection purchaser owns the reference asset, then he is in a better position with a cash settled CDS rather than a physically settled CDS. Please let me know if my thoughts below are correct.

Let's assume a market participant purchases a bond at par. Later, the issuer of the bond experiences financial distress and the bond price drops accordingly. Then, assume the issuer defaults.

Now, assume the the price of the reference asset after the issuer defaults is 30%, so the expected recovery is 30%.

Assuming the CDS is physically settled, then the protection buyer delivers the bond and receives par and par is the absolute max he can receive for the asset.

If the CDS is settled in cash, then the protection buyer receives 1 - 0.30 = 0.70 from the protection seller BUT he still retains the bond and, more importantly, the recovery right. So, if the recovery right is retained, there is some positive probability that the protection purchaser will recover more than the expected recovery of 0.30 and thus effectively receive over par! Thus, the cash settled position is better than the physical settled CDS from the protection purchaser's perspective.

I guess the actual recovery is irrelevant since the asset can be sold in the market at the expected recovery value.

 

[ShaktiRathore]

Yes Brian if the bond is not sold at the time of default by the cds purchaser then he can recover greater or lesser amount ,its his risk if he wants to retain it or not,if recovery increases its the reward of the risk he bears and he receives above par effectively i.e. The cash from cds+recovered amount, otherwise if recovery rate falls(further deterioration of financial condition) its possible that he recieves below par.
If recovery is made at the time of default also when cds is settled there is no difference whether u do physical or cash settlement,but in the above discussed case of retention of bond ,either physical or cash settlement would outdo each other depending on whether recovery rate falls or increases.
Thanks