Digital Premium

Digital default swaps are different from conventional (floating recovery) swaps because they transfer different types of risk. Conventional swaps transfer default loss risk, while digitals transfer default event risk. The implicit recovery risk remains unpriced in a hedged digital default swap. The digital swap break-even spread, calibrated to a market-observed conventional default swap spread, must incorporate a premium due to 1) uncertainty about the market average recovery rate, and 2) the inability to completely diversify firm-specific recovery rate deviations. These premiums are estimated in examples of pricing for underlying credits of various seniorities. The digital premium effect is in fact not restricted to digital swaps but is present in almost any credit derivative that transfers the default and the recovery risk in separated form