Hi, I have a question about the item 3 of the following CFA example (blue box). Any clarification would be super appreciated.
EXAMPLE 2 - Settlement Preference
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.
- Explain whether Investor Y would prefer to cash settle or physically settle his CDS contract or whether he is indifferent.
Solution provided by the text to 3:
Investor Y would prefer a cash settlement because he owns Bond B, which is worth more than the cheapest-to-deliver obligation. He will receive the same €7 million payout on his CDS contract, but can sell Bond B for €4 million, for total proceeds of €11 million. If he were to physically settle his contract, he would receive only €10 million, the face amount of his bond.
I don’t understand the following – If investor Y decided to physically settle, why wouldn’t he:
Go to the market, buy the cheapest bond & deliver this (bond A), since they have same seniority. Then keep bond B
Receive 10M cash from counterparty
It seems the exercise assumes investor Y will deliver bond B, just because he currently holds it, but why would you deliver something that is worth more?
So that payoff would be:
’ +10M cash → from counterparty; the CDS notional
’ - 10M * 30% → because of the market purchase for bonds A, which would be delivered
’ + 10M * 40% → because he’d still kept bond B, and now these are sold in the market at 40% par
= 11M (same as cash settlement)