Credit Derivatives: Trading, Investing and Risk Management, Second Edition

14

Digital or ‘Fixed Recovery’ CDS

14.1 PRODUCT DESCRIPTION

A digital CDS is similar to a vanilla CDS except that the payment in the event of a credit event is not par in exchange for defaulted debt (or par less recovery), but par. Similarly, a fixed recovery CDS is a CDS where the payment on the occurrence of a credit event is par less the agreed recovery.

The difference between a digital (sometimes called a ‘binary’) CDS and a fixed recovery CDS is merely documentation. For example, consider a digital CDS in EUR 10m on Fiat, subject to a premium of 600 bp. A fixed recovery CDS on EUR 12.5m with an agreed recovery of 20% pays 12.5 × 0.8 = 10m in exactly the same circumstances and conditions as the digital. The correct premium for the fixed recovery CDS is 600 × 10/12.5 = 480 bp, giving the same monetary premium for the same monetary protection in both cases.

Digital products are not very important in their own right - very little trading takes place in a simple digital CDS. Generally a digital CDS does not form a natural hedge for many risks, as most risks are in the form of bond or loan assets with an unknown recovery or equity risk, where a full loss is taken on the credit event but the forward exposure is unknown. The key feature of a digital CDS in valuation and risk management terms is the strong recovery rate sensitivity of the value of these products.⁴⁷

Digital risk arises in two main forms:

a. Off-market vanilla CDS positions and non-standard premium streams have ...