This is from reading 22 example 14, I am not quit sure about the answer about credit spread put and call answer
A credit spread put option where the underlying is the level of the credit spread.
A credit spread call option where the underlying is the level of the credit spread.
for spread put, why wouldnt having a spread put protect this buyer from a credit downgrade risk, and why credit spread call hedges increased spread risk, shouldnt it be decreased spread risk? so even when the bond is more expensive you can still buy it at cheaper?
You are right wrt credit spread call. However, wrt credit spread put, the buyer of the option will NOT get downside protection if the level of credit spread widens (due to bond downgrade, default or any other reason). This can be seen mathematically from its payoff formula as well i.e
Payoff (credit spread put) = Max[(K - Spread at the option maturity) X Notional amount X Risk factor),0]
It can be seen that if the Spread at option maturity widens a lot so that it gets above the strike spread (K), the put option will expire worthless and will not benefit the holder of the option. However, the seller of the put option will pocket in the premium in that case. So, its useful for the option holder only when the person believes that the credit spread will decline (and bond prices will rise in future).
PS: Its similar to a put option on stock, the only difference here is that stock price is replaced by credit spread (change in underlying).
Thanks. Is there a situation where we need to buy credit spread put option to protect credit spread goes down?
I think your confusion was between binary credit put option and credit spread put option. Binary credit put option is just contingent on a specific binary event and gives you protection in case the event gets triggered (like credit downgrade/non downgrade, bond default/does not default etc). In this case, if the triggering event happens, then you can exercise your put option if the underlying price falls below strike.
Credit spread put option is based on spreads and hence the payoff is different. The below situations will help further in understanding the concept:
Binary credit calls – Provide protection if price goes up due to credit event
Binary credit puts – Provide protection if price goes down due to credit event
Credit spread call – Provide protection if credit spreads goes up
Credit spread put – Provide protection if credit spreads goes down.
Thanks. Is there a situation where we buy credit spread put option to protect against credit spread goes down? For example, when are we negatively affected by credit spread goes down so that we have to buy a credit spread put option to protect?
Well as of now, the only example I can think of is when someone is receiving floating rate payments which are linked to the level of credit spreads.
For example, for an investor in a floating rate bond, or a fixed rate payer in a swap agreement (paying fixed and receiving floating), if we assume the payments are linked to the level of credit spreads, they will decrease as the spreads go down. In such case, the investor can buy a credit spread put option to protect against the loss.