Can a credit spread forward be used to cover the risk of a credit rating downgrade for a corporate bond issuer? #5 of Example 14, p. 27, CFAI vol.4 Can I say #5 can also cover bond by Company X? - sticky
My take on credit spread forwards are that the security is used to deal with the widening and shrinking of credit spreads (i guess that’s almost the definition). I guess when an issue is downgraded you would expect the spread to widen considerably. So i suppose is you expect Company X’s bonds to be downgraded a credit spread forward would help hedge that possibility. I’m not sure what hedign option (credit spread forward or a binary credit option desinged to protect from a downgrade risk) would provide a better hedge.
A forward would have to provide a better hedge than a binary option which is a pretty crappy hedge in most situations because it’s “binary” (which means it doesn’t track well) and an “option” (which means it pays off only in some situations). A forward means you have sold the risk to someone else.
As a PM, word of caution of using credit spread forward compare to binary credit option Credit spread forward CAN be used to protect downgrade risk, as striker pointed out, you would expect the spread to widen. Only risk is that credit spread forward is a symmetric instrument. Meaning, if somehow, by a act of God or whatever, credit spread is to narrow (to a point that the spread is less than the strike spread) you could end up paying out. Not saying that it will happen, but just be aware that credit spread forward has a symmetric payoff. Binary credit option has an asymmetric payoff.
if downgrade is supported by rise in spreads then yes a Long credit forward will benefit
ws Wrote: ------------------------------------------------------- > As a PM, word of caution of using credit spread > forward compare to binary credit option > > Credit spread forward CAN be used to protect > downgrade risk, as striker pointed out, you would > expect the spread to widen. Only risk is that > credit spread forward is a symmetric instrument. > Meaning, if somehow, by a act of God or whatever, > credit spread is to narrow (to a point that the > spread is less than the strike spread) you could > end up paying out. Not saying that it will > happen, but just be aware that credit spread > forward has a symmetric payoff. Binary credit > option has an asymmetric payoff. But the difference is “hedge” vs ‘protection’. The question I responded to was “I’m not sure what hedign option (credit spread forward or a binary credit option desinged to protect from a downgrade risk) would provide a better hedge.” and then the asnwer is clear.