A bond purchase or opening a line of credit usually involves some sort of credit risk. The negotiation of a physical settlement may protect the buyer from high credit risk and loss of assets.
A physical settlement describes the transaction in which a seller takes a defaulted loan or bond from a buyer at par value. This is usually done if the credit risk has become too high or if a negotiated credit event has occurred.
Physical Settlements and Credit Deratives
A credit derivative is a negotiated agreement that swaps credit risk from one party to another. Part of the derivative agreement may involve a physical settlement, where the seller assumes some of the risk to the buyer.
Physical vs. Cash Settlements
There are two main types of settlements: physical and cash. A derivative agreement is considered physically settled if there is a property or asset physically delivered for payment. Cash settlements offer the buyer the equivalent monetary amount of the asset, such as the market value.
Advantages and Disadvantages
The main advantage of a physical settlement is that it is not subject to change or manipulation by either of the parties involved, so both parties know exactly what will happen if the credit risk is heightened. A major disadvantage is the physical settlement does not allow for future changes or fluctuations in the market. As a result, cash settlements are generally the preferred method of settlement.