Binary Credit Options also Schweser exam 1pm #18.5

In answer to question 18.5 from exam 1 (Vol 1) Schweser states that “binary credit options can take the form of either puts or calls” even though neither CFAI or Schweser explicitly state so in their books. Binary credit put options provide protection against a rating downgrade. Then there is a binary credit option that provides protection against a default (would this be a put option as well?) My question is, what is binary credit call option?

see Schweser Book 3, p 80-81

Gaoyao - I’m finding a binary credit put option and a credit spread call option, but not the binary credit call option. Am I missing something?

I guess you don’t see much of those out there. Example will be if you expect your bond to be upgraded, and you want the pay off once the bond is upgrade. That will be a situaion for you to buy a binary credit call option.

binary call: will need to have rating downgrade and have spread over strike spread to be ITM and Credit spread just has to have a spread over strike right??

If there’s such a thing as a binary credit call option, then “ws” has it right. 3rd & Long - if we’re expecting a rating downgrade we would need a put option, not a call. to your question about credit spread - depends on on whether it’s a put or a call. If it’s a call, then yes, spread over strike, put is the opposite.

i believe, the spread and binary are contingent upon spread increasing… so if there’s a downgrade and an increase in spread you’d want a call…

3rd & Long - You’d want a credit spread call option when spreads increase. However, you’d want a binary credit put option in case of downgrade. (Schweser book 3 page 80-81).

However, you’d want a binary credit put option in case of downgrade. (Schweser book 3 page 80-81). ^ do is this the payout for the binary put : “Max ( 0, spread - strike spread) * Notional”?

^ do is this the payout for the binary put : "Max ( 0, spread - strike spread) * Notional ----------- No, the above is the payout for a credit spread call option (page 81), if you recall call is (S-X) and put is (X-S).

with a downgrade the spread increases don’t you agree? so what would the put payout formula look like?

The opposite of the Call :slight_smile:

If we purchased a binary credit put option, and if a downgrade occurs, the payout is as follows: OV=max[(Strike (X) - V(value of bond)),0], so if strike is 1000 and bond declined to 900 as the result of the downgrade, we get $100. I agree, that spread should increase, but we own a binary credit put option in this case, which works if a particular event occurs (e.g. downgrade). To work against a general credit spread increase, we should purchase a credit spread call option and you already described that formula above.

ahhh. thank you kindly…

Binary has only 2 outcomes: A) It’s downgraded B) It’s Not downgraded. It will only pay out on a downgrade and pays as Sa above stated.

there are more defined credit events than just downgrades

Binary===> black/white, 0/1. True/false, man/woman(well, this is getting blurred)

Hala, Yes, I was making an example.

I did this question yesterday or the day before and I don’t agree with the answer. I suppose in theory a binary call makes sense, but practically it doesn’t. If there’s a downgrade, why would you want to be long and what would be the strike price that makes sense? (With a binary put, par is the obvious and sensible strike price. No such symmetry for calls.) The Schweser practice exams are pretty good, I think, but their trick is always to make a certain amount of questions “tough,” and the “toughness” way too often comes through ambiguity. Another example was the one where the Crawfordville bank had a loan and they didn’t tell you whether they were the borrower or lender and asked you whether you should hedge with a cap or a floor.

Well, what irks me about Schweser, is that some of their exam questions can be a bit more comprehensive that their own notes. In case of binary credit options their notes are incomplete, which did not allow me to answer their exam question correctly. Only after I opened up CFAI text did I learn some useful details.