The contract specifies either physical or cash settlement. Exhibit 1 illustrates both settlement procedures. Physical settlement employs Deliverable Obligations, a class of obligations specified in the contract that are typically pari passu with the Reference Obligation. In effect, the Reference Obligation establishes the point in the capital structure referenced by the default swap. To physically settle the contract the protection buyer transfers to the protection seller one or more of the Deliverable Obligations with total outstanding principal equal to the notional of the contract.
Physical settlement is currently the most prevalent settlement method.
Ownership of the defaulted obligations allows the investor to participate in the workout process, potentially increasing recovery value. In the case of cash settlement, the protection seller pays to the buyer the difference between the notional of the default swap and a final value for the same notional of the Reference Obligation. Cash settlement is less prevalent because obtaining precise quotes can be difficult when the reference credit is distressed.