Terms
A recovery swap is an agreement between two parties to swap a real recovery rate (whenever it is ascertained) with a fixed recovery rate that can be locked in today. The parties are speculating on whether a company that is no longer liquid will pay out more or less than a certain percentage for each bond. The reference price is set to the fixed recovery rate rather than 100, chosen such that the RDS prices at zero on issue. Since the swap is issued at a price of zero, if the reference entity does not default in the term of the swap, then the swap expires with no cashflows having taken place.
Because the swap only has value (to either counterparty) during a default, the main market in RDS involves bonds that pose a high risk of default, when the reference entity (company) is in financial difficulty.
Read more about this topic: Recovery Swap
Famous quotes containing the word terms:
“I am happy to find you are on good terms with your neighbors. It is almost the most important circumstance in life, since nothing is so corroding as frequently to meet persons with whom one has any difference.”
—Thomas Jefferson (1743–1826)
“The research on gender and morality shows that women and men looked at the world through very different moral frameworks. Men tend to think in terms of “justice” or absolute “right and wrong,” while women define morality through the filter of how relationships will be affected. Given these basic differences, why would men and women suddenly agree about disciplining children?”
—Ron Taffel (20th century)
“I hope that you live on good terms with yourself and the gods.”
—Henry David Thoreau (1817–1862)