Granite Investment Bank provides investment and risk management advice to large investors. Granite also advises corporations on the issuance of securities. Jill Carr is a senior portfolio manager for the firm.
One of Granite’s corporate clients, Argyle Inc., is planning to issue a USD10 million, 5-year, fixed-rate bond. The firm has an AA credit rating and expects to pay a 125 bp premium to comparable maturity Treasuries (which currently have a 4.2% yield to maturity). Argyle’s CFO, Tom Davis, is concerned about possible increases in interest rates, but believes the spread to Treasuries will remain constant.
Granite also has an investor who would like to hedge the credit risk of a bond using either a binary credit put option or credit spread call option. The bonds were issued at par by the Stedman Corporation with a 5.5% coupon and an original 5-year maturity.
The strike price on the put option is 200 bp to comparable maturity Treasuries. The credit spread call option has a strike spread of 190 bp, a notional principal of USD10 million, and specifies the benchmark rate as the 4-year Treasury rate with a risk factor of 3.2.
After one year has passed, the bond’s rating has decreased to BBB, the yield to maturity (YTM) on 4-year Treasuries has fallen to 3.9%, and the Stedman bonds are trading with a YTM of 6.2%.
What is the value of the binary credit put option to an owner of USD10 million of Stedman bonds one year after bond issuance?
a) $ 246,700
b) $ 104,000
c) $ 102,500