If we are given two bonds where one is trading at 30% of par and the other is trading at 40% of par, why do we say that the recovery rate should be 30% for both?
If the two bonds are of similar seniority/ranking as the reference obligation, take the cheapest-to-deliver bond (lowest price) to calculate the payoff of the CDS.
yes, that i understood. But i didnt understand how this is related to the recovery rate
Typically speaking, because of many standard CDS trading assumes a recovery rate to be 40% in pricing model, which is a constant recovery rate assumption.
However, when the default occurs, which @fino_abama explained to you earlier, in order to maximize the payoff, the buyer of protection has the options to deliver and is likely to deliver CTD bond (Lowest cash priced bond) to the seller of protection. Therefore, the assumed 40% recovery rate can be misleading).