Settlements in credit derivatives

Let us try to understand the cash or rather the value flow in case of simple credit derivative contracts like CDS. Credit derivative contracts, are much like insurance contracts. So, one leg of the contract if the payment of premium which is upfront and paid periodically, like one pays one’s insurance premiums. This premium is unconditional and is to be paid till the contract expires by expiry of term or the credit event(s) happening.


We know that in most credit derivatives, on the occurrence of a credit event covered by the contract, a sum of money becomes due to the protection buyer from the protection seller. This conditional leg of the contract is contingent on the happening of the pre-specified credit events, else the contracts expires like an insurance contract. This leg, called the settlement, can normally be of three broad types – physical, cash or binary.


Cash – In a cash-settled credit default swap, no bonds or loans are delivered. Instead, the protection seller simply pays the protection buyer an amount of money calculated as the notional value of the contract minus the recovery rate.

Physical - After the credit event, with the delivery of a ‘notice of physical settlement’, the protection buyer delivers to the protection seller bonds or loans (‘deliverable obligations’) with a notional amount identical to the notional amount of the credit default swap. The protection seller then pays the protection buyer the notional amount of the credit default swap.

For example, for a standard Rs.10 crore contract on RIL, when RIL defaults, the protection buyer delivers defaulted bonds with a 10 crore face value and receives 10 crore from the protection seller. If the defaulted bonds are worth 4 crore (40% of their face value, where 40% is called the recovery rate), the protection buyer has effectively made 6 crore as a result of buying protection. The seller of protection could choose to sell the defaulted bonds, so achieving their recovery value.

Binary – Also known as ‘digital’ credit default swaps, here the settlement amount is pre-determined and the post facto recovery rate is ignored as it is fixed at the inception. For example, if two counterparties trade Rs.10 cr CDS on RIL with a 40% fixed recovery rate, the protection seller will simply pay the protection buyer $6 million in the event of a default by RIL. The post event recovery from RIL will not impact the settlement of the contract.

This form of a settlement is simple because estimating recovery rate is difficult and can take time. But the disadvantage is that the protection buyer doesn’t know if she is adequately hedged.