CDS - Cheapest to deliver

How do you know a bond is the cheapest to deliver?

When it is the “cheapest” …

lowest price that you would deliver among all the bonds of similar maturity, etc. etc. available with you.

what is the logic of this? So you would look at all the factors (maturity, coupon, etc.) and determine the price based on that?

The prices are set by the market. The basic concept here is that the short position has an option to deliver “deliverable issues” that allows it to maximize profit or minimize losses. That will be established by the market prices on the deliverable issues (or the implied repo rate, which is more or less the same thing as a market price).

On the day that the short has to deliver its bonds, it looks at the market prices of all eligible bonds, compares those prices to the conversion factors, and buys the deliverable set of bonds that cost the lowest amount of money.

I’m missing something fundamentally here on CDS, so would love some clarity:

The Protection seller on a CDS has the option to deliver the ‘cheapest to deliver’ bond to the Protection Buyer when a credit event takes place. However, the payoff on the CDS to the protection buyer is the original notional principal - new market value on the bond.

Thus, why would the protection seller, who must reward the protection buyer by paying him when the bond defaults or a credit-event occurs, want to deliver the ‘cheapest’ bond when the payoff is a result of the difference between the original notional principal and the new market value?

i.e. - if a bond is trading at 10% of par and is the cheapest to deliver bond, why would the protection seller want to use that bond when the amount they must pay is (1 - 10%)? Why wouldn’t they want the most expensive to deliver bond so their payoff would be lower?

I’m clearly missing something about the fundamental structure of CDS payments and would love any guidance.

Thanks in advance.

You have that backward: the protection buyer delivers bonds; the protection seller delivers cash.

(Of course, most CDS buyers don’t own the bonds, so they deliver nothing; the protection seller delivers cash, but less cash than if the buyers had delivered bonds.)

I’m sure that they don’t want to; they’d rather pay off on the expensivest-to-deliver. But the rules say that they have to pay off on the cheapest-to-deliver. Dem’s da rules.

You’re welcome.

In order to make sure I got it right!

The buyer of protection receives (1-CTD bond) not the 100% because he will be able to sell the bond later by the CTD value, or he want be able to since the bond issuer defaulted.

If he will not be able to sell it, then why the seller of protection does not pay 100% of the bond value since the buyer of protection has already paid the seller a spread for this protection?

When a bond defaults, the buyer of the CDS is entitled to the notional principal minus the recovery rate of the bond. The recovery rate of the bond is considered its value immediately after default.

Credit swaps can be cash-settled, where the CDS seller pays the CDS buyer the amount by which the bonds or other referenced financial instrument devalues because of the credit event. In a physical settlement, the seller buys the bonds from the buyer for their par value.

With a physical settlement, most CDS contracts allow the buyer to select from a number of different defaulted bonds to deliver to the CDS seller, although they must have the same seniority. Thus, the CDS buyer usually has the option of delivering the cheapest-to-deliver bond to the CDS seller. In the case of a cash settlement, the calculation agent will use the cheapest-to-deliver price to determine the cash settlement.

To summarise, CDS contracts give the buyer the right to deliver the cheapest-to-deliver bond to the seller. Hence, the payout ratio is that of the cheapest-to-deliver bond in the same seniority

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