CDS protocols - question about exercise

CFA Level II Fixed Income
#1

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.

  1. 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)

#2

The answer is right. The CFAI explanation and the qs is poorly drafted. At the heart of it, there is no “preference” in an Insurance contract. Either it is cash settled or make whole against the physical submission. The latter being more common.Through a process called “subrogation” the Insurance company assumes all the rights on the assets that suffered loss. Once settled if there is a recovery or any upside potential that would accrue to the Insurance company as the Insured would have rescinded all his(her) rights to the assets.

The qs. presented here is hypothetical and is meant for comparison purposes only. One of the two happens not both.

Rest of the math you got correct. It is a simple arbitrage rule that governs. An asset trading at 40% of its par would naturally have more upside potential and thus recovery to its par than the one trading at 30%. Given a choice , I would deliver the 30% asset and collect greater CDS payoff and still enjoy the probable upside potential of the impaired asset. Be as it may, in reality it cannot be so. One argument could be what if it is a naked contract ? Well in that case the qs. does not arise at all. It will be cash settled and the Investor would simply be compensated to 70% of par assuming Bond A is the Cheapest to Deliver.

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