CDS Auctions and Recovery Rates: An Appraisal

Abstract

Among the most important types of derivatives to appear in recent years are credit default swaps. The ability of CDS to separate credit risk exposure from ownership of the debt securities issued by a risky borrower is a major step in risk management. But the mechanics of the CDS market have been problematical, including the fact that there can easily be more protection purchased and sold through CDS than there are bonds subject to that risk in existence. Originally, in the case of a credit event the protection buyer would deliver bonds issued by the defaulting borrower to the protection seller, who was obligated to buy them at par value. This physical settlement process has recently been replaced by cash settlement, in which the payoff is based on bond prices established in an auction of the deliverable bonds. But as Sundaram explains, this is not a simple auction. In this article, he describes its complexities and comments on its potential problems. <b>TOPICS:</b>Credit default swaps, exchanges/markets/clearinghouses