Which method of settlement is allowed if a credit event occurs in a Credit Default Swap (CDS)?

In the context of a Credit Default Swap (CDS), when a credit event occurs, the method of settlement can indeed be either cash or physical settlement. This flexibility is a defining characteristic of CDS contracts.

Cash settlement typically involves the payer of the CDS making a payment to the protection buyer, which generally reflects the difference between the par value of the bond and its recovery value after the credit event. This allows for a straightforward financial transaction without the need for the actual physical transfer of the reference asset.

On the other hand, physical settlement means that in the event of a default, the protection buyer can deliver the defaulted bond to the protection seller in exchange for the notional amount of the CDS. This method caters to the situation where the protection buyer prefers to recover the face value of the bond rather than settling monetarily.

The allowance for both cash and physical settlement in the event of a credit trigger ensures that all parties can choose the method of settlement that best suits their needs, aligning with their financial strategies and positions. Consequently, having both options provides a balance of convenience and flexibility depending on the circumstances surrounding the credit event and the involved parties' requirements.