The recovery rate in the context of CDS valuation indicates the percentage of the bond's face value expected to be recovered after a default. When a financial risk manager calculates the expected payoff from a default event, they factor in the loss given default, which is the portion of the bond's face value not recovered. This is represented by (1 - recovery rate). Hence, to adjust the payoff amount, they multiply the default probability by (1 - recovery rate), effectively calculating the expected loss, which is critical for the accurate valuation of a CDS.

B is incorrect. Adding the recovery rate to the default probability would not correctly reflect the anticipated unrecovered amount.
C is incorrect. Adjusting the default probability for conservatism is not the purpose of the recovery rate.
D is incorrect. The recovery rate is not applied directly to the expected payments but to the expected loss in case of default.

Things to Remember.

• The recovery rate is used to adjust the loss given default, which affects the expected payoff in CDS valuation.
• A higher recovery rate reduces the expected loss and, therefore, the cost of credit protection within a CDS.
• Recovery rates can vary depending on the credit quality of the reference entity and the seniority of its debt.