# Credit Derivatives

All of these credit derivatives are positive to the long when spreads widen, correct?

Examples:

1. Credit Spread Call Option - payoff would be: [0, (spread @ maturity - Strike spread)] * Notional * Risk factor - inital cost. (Obviously a credit spread put would be opposite of this - meaning payoff is positive to the long if spreads NARROW, but for drawing similarities let’s ignore that for now.)

2. Credit spread Fwd - payoff: (spread @ maturity - contract spread) * Notional * Risk Factor

3. Binary Credit Put Option - payoff: (Strike - Mkt Value of bond) - initial cost

Now, the binary credit option technically doesn’t deal with spreads, only Market value due to negative credit events. However, my thought on this is that if a negative credit event happens the spread on the issue will likely increase (e.g. widen) which will cause the mkt value to decrease and create a positive option value for the long put.

Are there any credit derivative calcs that I am forgetting here? I didn’t include the CDS information since I don’t believe there are any formulas for them, they are only conceptual in the books, correct? Thoughts?

Great post - I agree with you although I’m not too savvy on this topic.

Now, the binary credit option technically doesn’t deal with spreads, only Market value due to negative credit events. However, my thought on this is that if a negative credit event happens the spread on the issue will likely increase (e.g. widen) which will cause the mkt value to decrease and create a positive option value for the long put.

I don’t think you should MIX UP the event on the option with the effect of the event.

E.g. - Credit event occurs. Because of that we know that the spread will widen. But that does not mean that some other derivative instrument that deals with that event would apply in this case.

Just note that particular point.

choice is also based “underlying events”…whether it triggers payment when the “underlying spread or price or downgrade etc” happens…

there was one question relating to this. There we were given all this choices & we had to identify which one will be beneficial according to expectations…unable to find it now…

Rahuls- are you refering to the blue box example 14 in the book? volume 4 pg 126-127? I have that one highlighted - it’s a good example to test your knowledge!

would it be correct to say :

To insure against a general widening of credit spreads - > call credit spread option

To insure agains specific credit events - > long binary credit puts?

thx

Yes Fin…the same one…thanks! let me read it again

SCH has one small numerical for CDS in book 3 P no 89 (2010) edition…

but it just says after default bonds trades at 60 cents to dollar…so not heplful as such…

That sounds right to me. However if you are sure of spreads widening it would be cheaper to use the credit fwd. Otherwise if you are unsure whether spreads will widen or narrow, the credit spread call option is best.

this is how i see it, hedging the following risks

1)default risk - use options or swaps

2)spread risk - use options or forwards

3)downgrade risk - use options or swaps