As I understand it, recovery swaps and CDS are both used to provide hedging against the default risk of a loan.
What is the difference between them?
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3$\begingroup$ From this definition: Recovery swaps are usually traded as zero-premium credit default swaps with the reference price set at the fixed recovery rate rather than 100. And here is a paper that discusses their pricing. $\endgroup$– chrisaycockMay 28, 2013 at 11:29
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$\begingroup$ Recovery swap is a hedge against the recovery rate risk, not against default risk. $\endgroup$– quant_devMay 28, 2013 at 17:03
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1 Answer
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CDS provides protection against default. So when a firm is unable to pay the coupon (and there are few more scenarios where firms default) CDS is triggered.
After default the liability holders have first claim on the firm's assets. If the assets are less than loan (say 60% of loan amount) then recovery can only be 60%.
if these are risky assets and there is possible uncertainty in the asset value from the time of default to recovery payout one can buy recovery swap or recovery default swap to provide a hedge against the such uncertainty of recovery in default.
Hope that makes sense
