Does physical settlement on a long CDS position already assume that you hold the underlying bond itself?
The only way that you can deliver something is if you have something to deliver.
What happens if you hold a CDS on bond that you do not own? Would you be able to physically/cash settle in this situation?
You can buy a put option and not own the stock associated to it… THen if you want to exercise, you can buy the stock on the market… normally ou just cash settle it by taking an opposite position and close it out. Or selling the position.
^ Taking an opposite position is not required for a long put option position closing. Just leave it to expire if not executed. Taking an opposite position to close the current one is the feature of FUT trading. Also why would you buy a stock to exercise an option if you already own a put?
Given what I wrote above, think about it and you tell us the answer.
If you don’t own the bond, can you settle it physically?
Ok, just to confirm, you cannot physically settle on a CDS position if you do not own the underlying bond on the CDS.
So, lets say that you ONLY own a CDS contract (do not own the underlying asset itself) you would not be able to physically settle the CDS position because you do not own the underlying bond asset? I am assuming this is a correct way to summarize what you are referring to.
This is basically an analolgy to owning a put option on an asset, when you do not physically own the asset
That’s correct.
Just a followup question, does the cheapest to deliver obligation on the bond only relevant under the cash settlement for a CDS?
Meaning that using a physical settlement option on the CDS contract delivery would not incorporate the cheapeast to deliver provision.
The CTD always applies _ only to cash settlements _.
How would the CTD be relevant under a physical settlement for CDS? Since under a physical settlement the notional (par) value on the bond is exchanged for the bond itself (no CTD calculation is applied in this scenario).
My mistake; you’re correct: the CTD applies only for cash settlement. I corrected my statement above.
(Note to self: don’t reply to threads immediately after brushing two dogs; too much fur in the eyes, ears, nose, and throat interferes with the synaptic processes.)
So let’s say a particular investor owns a senior lien bond and also a senior lien CDS. The senior lien bonds have experience a credit event, so the senior lien CDS is expected to be exercised by the long position.
So I understand how under a physical settlement , you must own the underlying asset in order to provide the underlying asset to the short CDS position during a credit event (thus the payoff to the long position would be the notional principal).
Let’s say I instead want to use a cash settlement instead of a physical settlement. How come we would require the investor to also sell the underlying bond if we decide to use a cash settlement?
From what I read in the text, the payoff on a cash settlement is the payout ratio (determined via CTD) X notional amount. But does not mention anything about having to sell the underlying asset ITSELF.
Like a put option, the payoff is determined on the status of the underlying asset itself, but this does not require you to actually sell that asset in order to receive the payoff on a put option.
There’s no requirement to sell the underlying bond.
“A French company files for bankruptcy, triggering various CDS contracts. It has two series of senior bonds outstanding: Bond A trades at 30% of par, and Bond B trades at 40% of par. Investor X owns €10 million of Bond A and owns €10 million of CDS protection. Investor Y owns €10 million of Bond B and owns €10 million of CDS protection”
The question above is asking whether a cash settlement vs. a physical settlement would be more profitable for investor Y.
Physical settlement generates payoff for the investor of 10 million (makes sense).
Cash settlement generates payoff for the investor of 11 million (7 million from the payoff of the CDS + 4 million from selling the underlying bond)
In the cash settlement, I understand the payoff on the CDS of 7 million, but do not understand why they are including the 4 million (selling of the underlying asset). Selling the underlying asset does not have to do with the payoff on the cash settlement of the CDS.
If they sell the bond, they get 4 million in cash.
If they keep the bond, they have an asset worth 4 million.
Either way, their payoff is 11 million.
I guess I am confused why they use payoff as the terminology in the book. Usually payoff is based upon a realized gain when you sell an asset, Thats not true in this case.
Sloppy terminology.