A scenraio for CDS

[sudeepdoon]

Hi David,

I was wondering that in a CDS :

The protection buyer gives a premiun to the protection seller for the protection; which is the profit for the protection seller in case there is no default. Where as in the case of a default the protection seller pays the buyer and the seller gets to have the defaulted security (In case the buyer owned it) so that he can claim recovery..

Now is the follow senario possible :

The premium for the CDS say is $20; and the underlier has a high seniority.. Now in the case of the credit event...
the protection seller pays the buyer the par value of the underlyer..say $90.. and gets the defaulted security.. on which he claims the recovery and because of high seniority the recovery is say : $80 (I guess its high but still...)

In this case the cash flow for the protection seller is : +20 -90 +80 = $10..i.e. a positive cash flow..

The quesions to you would be :
1. should this positive cash flow sound wierd ?
2. Can this be a valid market scenario?
3. If the possible recovery rate is so high .. would the premium be low... (because of low risk for the seller... may be this is the reason then for this abnormal seeming cash flow !)

 

[David Harper CFA FRM]

Hi Sudeep,

1. Although it sounds unlikely, the scenario seems (to me) possible. The key as you suggest is that realized recovery is far, far better than anticipated (ex ante, in the pricing) recovery. If the priced-in recovery rate is low and actual recovery is high, it seems mathematically possible that the protection seller cumulatively is better off (actually, i don't think physical settlement is necessary assumption. Even in cash settlement, the seller payoff is a "net of recovery" cash payment, so your scenario seems possible there too...)

2. I don't know of it specifically, but it *reminds* me of Amherst. From june:
http://blogs.reuters.com/felix-salmon/2009/06/11/amhersts-cds-coup/
http://online.wsj.com/article/SB124468148614104619.html#mod=testMod
... this was fascinating...the protection seller (hedge fund) was collecting very large (crazy high!) CDS premiums, and meanwhile managed indirectly, to retire (pay off) the depressed-price bonds, which cancelled the CDS. As the cumulative premiums exceeded the cost to retire, they profited! (I don't have sympathy for the protection buyer counterparties because they were likely speculating themselves - must of the CDS trading was spread speculation - the counterparties who sued, the protection buyers, you can bet didn't own the underlying; they bought expensive protection on the hope that the CDS value/spread would increase)

3. Yes, great question...you can take a look at this XLS of Hull's CDS valuation:
http://www.bionicturtle.com/premium/spreadsheet/2008_credit_hull_ch_21_credit_default_swap_cds_valuation/
estimated (ex ante) recovery must be part of the spread pricing...if you were to (hypothetically) increase recovery to 100%, the CDS premium would drop to 0. But, as your scenario implies: recovery is hard to predict, the realized recovery can be > estimated (priced-in) recovery

David