I’m having a really hard time understanding the CDS settlement concepts. I am trying to understand an answer to a practice question and the answer doesn’t really explain it to me well. Question and answer below and then my specific questions below that:
Haruto Nakamura, CFA, is the chief investment officer for Tanaka Advisers in Tokyo, Japan. He manages a diverse portfolio of corporate bonds, and his investment portfolio holds a JPY 1,000,000,000,000, 10-year, senior unsecured bond issued by Goodbye Doggy, a company that sells popular teen clothing and fashion. The bond has a 6% coupon. Nakamura also owns a JPY 1,000,000,000,000, five-year, senior unsecured bond with a 5% coupon.
Concerned about the portfolio’s exposure to Goodbye Doggy bonds, Nakamura purchases a JPY 2,000,000,000,000 CDS with a reference obligation to the 10-year bond owned by Tanaka. He prefers this CDS to an Asian CDS he has considered that includes Goodbye Doggy and 124 other companies. Part of his preference for the CDS he purchases is that the Asian CDS covers losses only up to 10% of the notional amount. The duration of the CDS he purchases is eight years, and the credit spread is 900 bps. Interestingly, CDSs with a one-year duration trade at 3,500 bps.
In six months, Goodbye Doggy misses an interest payment on its bonds, but it does not declare bankruptcy and says it is committed to fully repaying its debt. In fact, on the day interest is due, Goodbye Doggy announces an LBO and says the missed interest payments will be made when the deal closes. Nevertheless, the 10-year bond on the company trades down to 85% of par and the five-year bond trades at 80% of par. The only subordinated unsecured bond on the market trades at 75% of par. All other senior unsecured bonds trade closer to par.
Nakamura’s proceeds from settling the CDS contract will be closest to: 2,050,000,000
Answer: Nakamura should cash settle the contract and sell the bonds. The five-year bonds are the cheapest to deliver, so he would net the same proceeds for them and would have no preference for cash settlement or delivering the bonds.
(1-0.8) x 1,000,000,000,000 = 200,000,000,000
However, he can cash settle the 10-year bonds for JPY 200,000,000,000 and then sell the bonds for JPY 850,000,000,000 on the market, netting JPY 50,000,000,000 more than he would receive in a physical delivery, providing 2,050,000,000,000 in total proceeds.
My questions here:
Nakamura already owns the bonds. So since the CDS seller has to pay I understand that the 5 year bond issue is the cheapest to deliver of the same seniority so he should be receiving (1-.8) x 1 trillion = 200billion. OK, that makes sense so far, so in the next part of the answer it says that he can cash settle the 10 year bonds and then sell them? OK so that means since the 10 year bonds are at 85% of par, he can sell them for 850 billion. So 850 billion + 200 billion = 1.05 trillion. But then the answer says that his total proceeds are actually 2.05 trillion. It’s as if the original notional amount is being added back into his proceeds? How does that make sense exactly, he isn’t actually receiving another trillion dollars?
Thanks again to anyone that actually reads through this and can help!