Senior Managing Director Boris Steffen's article "The Net-Short Debt Strategy Paradigm" was recently published in the Association of Insolvency & Restructuring Advisors (AIRA) Journal. Boris provides an overview of credit default swaps (CDS) and discusses the actions taken to implement a net-short debt strategy which fall into two categories: the "net-short debt activist" approach, and the "manufactured default" approach. He includes examples of companies affected by CDS contracts such as Windstream, Codere, iHeart and Hovnanian.
See below for an excerpt from the article.
When two parties enter into a CDS, the spread is set
such that the present value of the swap transaction is
zero, with the value of the fixed, or premium leg, and value of the contingent, or protection leg, equal. Stated differently, the present value of all CDS premium
payments should equal the present value of the expected
payoff from the CDS in order for the NPV to be zero
for both parties. If the reference entity subsequently
defaults, the CDS buyer will receive a payment from
the seller. However, as the recovery rate (i.e., degree to
which the principal and accrued interest on defaulted
debt can be recovered) is typically greater than zero, the
payoff will differ from the face value of the obligation.
Accordingly, the payoff from a CDS is equal to the face
value of the credit asset minus its market value just after
default at time t, with the market value just after time t
equal to the recovery rate multiplied by the face value
of the bond plus accrued interest. So with a failure to
pay or other credit event under a CDS contract, credit
protection sellers must pay credit protection buyers the
amount of the percentage decline in the par value of
the "cheapest to deliver" debt of the reference entity
deliverable under the CDS, multiplied by the applicable
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