What is the Difference between Auction Recovery CDS and Fixed Recovery CDS?
How is the CDS settled if the credit event happens?
Physical settlement (used to be prevalent in the early days, the 1990s) means that the protection buyer gives the protection seller the reference obligation (or another debt security pari passou with the ref ob), and the protection seller pays the protection buyer the notional face value. (similar to exercising a put.) It is not necessary to figure out what the defaulted debt is worth under physical delivery.
Cash settlement with floating (auction) recovery (by far the most common these days) means that an auction is held soon after the credit event that determines how much the defaulted ref ob is worth. The protection seller than pays to the protection buyers the notional minus the floating recovery from the auction.
Cash settlement with fixed recovery (much less common than floating recovery) means that the buyer and the seller agree at the inception of the swap what price to use for the defaulted ref ob. The protection seller than pays to the protection buyer the notional minus the fixed recovery. The fixed recovery is usually 0 (i.e. the protection seller pays the full notional to the buyer), but I've seen contract with 40% fixed recovery as well.
One can combine a fixed-recovery CDS with a vanilla CDS to take a view on what the recovery would actually be.
It is easy to see that if you mark to market a fixed-recovery CDS using vanilla CDS quotes (which are much easier to observe in the market) then the mtm has much higher sensitivity to the recovery assumption than the MTM of vanilla CDS.