 # Binary credit Put Value

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

B

5.45 = 4.2 + 1.25 was the original AA rating Bond

5.5% was Stedman bond.

Now with 3.9% treasury yield - AA bond would have been 3.9 + 1.25 = 5.15 Stedman bond is 6.2 So credit spread now is 1.05%

Put option = Max (0, 0.02 - 0.0105) * 10,000,000 * 3.2 = 304,000 ?

cpk,wouldnt that be for the credit spread put option as opposed to the binary credit put option?

I am not sure what is to be done …

Is it C)?

Strike Value would be calculated as:

PMT= 5.5, I/y = 3.9 + 200 bps = 5.9, FV = 100, N = 4, PV = 98.6108

Value at maturity =

PMT = 5.5, I?Y = 6.2, FV = 100, N = 4, PV = 97.5851

Credit Put Payoff = max [0, (Strike - maturity value)] = (98.6108 - 97.5851) = 1.0256 * 10,000,000 *.01 = 102567

i got (B)

Payoff of binary credit put = X-V(t)

where

• X=CPT PV,N=8,I/Y=(3.9+2)/2,PMT=10000000*0.055/2,FV=10000000
• V(t)=CPT PV,N=8,I/Y=6.2/2,PMT=10000000*0.05/2,FV=10000000

i get X-V(t)=103966.5654

is this right??

this question is god awful and I think all the answers offered are wrong.

1. the strike is 200 bps over “comparable treasuries” which means it is a reference spread rate of 200 bps over treasuries (T+200). it is a reference spread credit option, and the relative spread is what dictates the payoffs.

2. the spread at expiration is (620-390) = 230 bps.

3. the put option is in the money 30 bps

4. 30 bps * 10,000,000 (notional) * 3.2 (risk factor) = 96,000 payoff

Binary Strike price is the PV of the bond (5.5coupon, 4 years maturity) PMT = 5.5/2= 2.75, FV=-100, N=8, I/Y = (3.9+2)=5.9/2 = 2.95, CPT—.PV=98.59 Currently bond is trading to yield 6.2% so PV of bond = 97.55, (I/Y=6.2/2=3.10) Value = (98.59-97.55) /100 * 10 mil= 104,000 FYI : Ques is from Qbank

crazy. if that’s on the test, i’d be shocked.

But it is a good question to consider , quite CFAI like ( causes just enough confusion in your mind to confound ) , yet the answer is obvious once you know .

Thanks rahuls

What a question!

Is this an item-set question? If yes, what’s Q#?

tulkuu

i guess Question ID#: 117136

Thanks, rahuls.