Recovery Swap
Recovery Swap
Recovery Swap
In finance, recovery swaps, recovery locks, or recovery default swaps (RDS) are derivative contracts
related to credit default swaps, and reference a bond issuance as its underlying. They are designed to
provide a hedge against the uncertainty of recovery in default.
The International Swaps and Derivatives Association does not keep records on the size of the recovery
swap market because there has not yet been sufficient member demand.[1]
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.
References
1. John Detrixhe. "Citigroup Peddles Default-Recovery Swaps as Bankruptcies Soar" (https://w
ww.bloomberg.com/apps/news?pid=20601084&sid=a_L5pzskD4rU). Bloomberg. Retrieved
2009-11-15.