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.
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