“The CDS pays off not only when the reference entity defaults on the reference obligation but also when the reference entity defaults on any other issue that is ranked pari passu (i.e., same rank) or higher. The CDS payoff is based on the market value of the cheapest-to- deliver (CTD) bond that has the same seniority as the reference obligation.”
Kaplan
…thus in examination there are given 3 or 4 bonds. First we eliminate those which are not pari pasu and
then ussualy 2 of them left. Then, it says, according to cheapest to deliver we should choose one valued with less % of par than other. Ex. between Bond A senior unsecured trading 20 % of par, and Bond B unsecured trading 30 % of par, we should choose that with 20 % diccount because it is cheaper for deliver for CDS issuer.
Why? Is it not CTD Bond B with 30 % discount, because payoff B principal, ex. $ 1000.000 - 30% ($1000.000) is $700.000.
Bond A would be 20 % discount, because payoff B principal, ex. $ 1000.000 - 20% ($1000.000) is $800.000 but this one is CTD. Thus how $800.000 may be CTD compared to $700.000. It makes no sense.
I also checked in official curriculum and the concept is same.
If own Bond A, you’re indifferent to a cash payoff or physical delivery:
- With a cash payoff you get $800 and you own a bond worth $200: total is $1,000.
- With physical delivery you get $1,000, but you deliver the bond: total is $1,000.
If you own Bond B, you prefer a cash payoff to physical delivery:
- With a cash payoff you get $800 and you own a bond worth $300: total is $1,100.
- With physical delivery you get $1,000, but you deliver the bond: total is $1,000.
Thanks Magician but still am not sure that I understand this concept.
By aspect from CDS issuer, is it not cheaper to buy bond B on the market for $700.000 and deliver to another party (CDS buyer) than buy Bond A for $800.000?
I remember discussing this two months ago. We went quite deep into the example.
http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91348813
OK, thanks.
I asked from position of CDS seller not a buyer. But Magician explanation is also worth since it covers same concepts and may be a part of same question.
So assuming there are only 2 bonds on the market. CDS seller bought one for 800.000 with 20 % discount, then deliver s it to buyer. Why CDS seller did not choose 30 % disocunted bond as CTD? I searched the web and did not find valid explanation so I am on the way to remember this is such rule and why is that I dont’t know and it doesn’t matter since I am not a fixed income and CDS specialist.
I think the confusion is this: 20% of par is not 20% discount. After a default the bond is not trading at 20% discount (800,000). Its price is 20% of par, i…e. it is now worth only 200,000. So in that sense 20% is cheaper than 30%.
The CDS seller doesn’t get to choose which bond qualifies as the CTD. The CTD is the bond trading at the lowest market price.
Explanation is. “Bond A would be 20 % discount, because payoff B principal, ex. $ 1000.000 - 20% ($1000.000) is $800.000. This one is CTD”.
Thus your explanation about understanding discount only holds. Otherwise it will be “The most expensive to delivery” instead. Thank you both for helping me clarify this.