Physical Settlement vs. Cash Settlement in Credit Default Swaps
In a credit default swap, the credit protection buyer pays a fee to the credit protection seller to protect him from the default of a reference asset. As protection, the protection sell will make the payment to the protection buyer on the occurrence of a credit event.
When the credit event occurs, the swap contract terminates, and the settlement payment is made. The amount of settlement payment will depend on the exact details of the contract. The settlement can either be cash settlement or physical settlement.
In case of the cash settlement, the protection seller makes payment equal to a pre-determined value to the protection buyer. The obligation will be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its current value, that is, it will compensate the protection buyer for the decline in the obligation's value.
In case of physical settlement, the protection sell will pay the face value of the asset to the buyer and the buyer will give the reference asset to the seller. The contract may also specify the alternative assets that can be delivered. If the contract has more than one alternative asset mentioned in it, then the buyer will always deliver the one that is the cheapest among them all. This is where the concept of cheapest to deliver comes in.