I am a little confused as to when you would prefer cash or a physical settlement? Seems very straight forward but I can’t get my head around the payoffs… Can someone please explain?
If i own a $100 notional bond that’s worth $40 after default, and have bought $100 credit protection on the bond, and the cash settlement price is $30 (the “cheapest to deliver” set by the ISDA auction process), i would prefer cash settlement to physical settlement.
In a cash settlement scenario: I get a recovery on my CDS of $70 ($100 - $30) and sell my bond for $40, total payout = $110
In a physical settlement scenario: I deliver my bond in exchange for par, total payout = $100
Here, i prefer cash settlement because the cash settlement price is less than the value of the bonds i would deliver.
If you don’t own the bonds, you have to get a cash settlement. This is the more common case.