Can you explain Credit Default Swaps?

Why do credit default swaps pay based on recovery rates, instead of acting as a conditional put on the bond in question?

• The way I've heard credit default swaps explained is that if I buy swaps on Acme Co's debt, and Acme defaults, I wait until the recovery amount is decided, and get paid based on that. So if bondholders get 15 cents on the dollar, I get 85 cents for every dollar of bonds I was betting against. But that introduces some lag time: once there's a default, the CDS buyer's thesis has been mostly proven, but now they have to wait a while to find out exactly how much. The transaction costs on buying an offsetting CDS contract are presumably fairly high compared to the cost of trading the underlying bonds. So why not have the CDS contract function as a conditional put? In the event of default, I can sell the bonds I bought protection against to my counterparty at 100 cents on the dollar. This seems to have several advantages: - It's cheaper to close out. - It reduces transaction costs for someone buying swaps against bonds they already own. - The party writing the swap is implicitly long the bonds already, so if they take delivery of bonds, it doesn't affect their economic value (though that would change how CDS contracts show up on your balance sheet between the default event and the recovery determination). So, what am I missing?

• Answer:

  You basically highlighted the difference between CDS for which compensation is paid to the protection buyer via "physical settlement", as opposed to "cash settlement." Cash settlement is less common exactly because the cash payment would be equal to the difference between par and the final value of the distressed reference obligation -- and that can be tough to figure out.  In practice, though, there isn't much of a delay in making payment.  Ususally the protection seller is required to pay within five business days of receipt of notice of the credit event. The CDS agreement needs to specifiy how the parties will resolve disputes about the final value of the obligation. Physical settlement is much simpler: the protection buyer sells the distresed obligation to the protection seller at par.