sparty419 Wrote: > So if you are a buyer of a credit forward, you > gain if spreads widen? Hows that? If you are > locked in with a lower spread (higher price) and > spreads widen, aren’t you actually paying a higher > price than the contract? You and your counterparty in a credit spread forward bet on different direction of credit spread in order to either hedge an existing bond position or just speculating. Let’s say you hold bond A and you predict the issuer’s credit spread will widen within 3 months, which will result in decrease in bond A value. In order to protect yourself, you purchase a 3-mo. credit spread forwards from a counterparty. You will receive a payment from your counterparty 3 months later if the credit spread is > strike spread of your contract. The payment may not exactly match your bond A lose value, depending on how you set up the risk factor in the contract initially. Your gain from the forward somewhat offsets your loss from bond A position. Note that you will end up pay your counterparty instead if the credit spread turns narrower at contract maturity. At the same time, your loss offsets by your gain from bond A position to certain extent. > > Same thing with credit option call spread > contracts. You gain when spreads widen? Don’t you > take into account the price changes? Isn’t a total > return perspective much better than just a yield > perspective? My opinion is-- Many factors can cause price changes–interest rates, downgrade, default, mkt supply & demand, credit spread etc. There is a variety of derivatives to hedge different risks. --Perhaps there is not a cost-effective way to hedge all risks. --Mgrs. always want to expose to certain risks in order to earn additional return and hedge others based on their forecast. They use specific derivatives to modify their exposures.
James@Houston, Agree with your explanation. TKVM !
James…that made a lot of sense…I seem to be using only half my brain these days it seems. should have thought of it from the credit loss perspective as well…appreciate it !
Sparty, u’re very welcome. Actually all your questions were valid ones. We are all here because we search for answers and help others to search theirs. I found looking at other’s questions can help to look at the same fact from a different angle. It really helps to answer exam Qs especially some of the AM essays.
This is how I think about these: Credit options (aka binary options) Related to price of the underlying. Can be a call (bet price is going up) or put (bet price is going down). Price action itself does not trigger a payoff, has to violate one of the terms in the contract that would define a credit event. Credit spread options: Related to credit spread of the option. Can be a call (bet spread is widening) or a put (be spread is tightening). Credit spread movement is itself considered a credit event, so no need to evaluate as seperate factor Credit forwards: Related to credit spread of option. Valued like a usual forward, but as opposed to just a spread or reference rate, specifically refers to the credit spread Credit swaps: allows for credit risk transfers. CDS is most common; can: Buy CDS: Why? own the bond and want to hedge risk, or shorting the bond synthetically; Transaction: pay upfront for protection as well as periodic CDS payments; pay out if credit default event occurs. (defined in contract terms - there is some flexibility in terms of what defines “default”). can also sell if the CDS spread blows out (for example, you buy GE CDS at 45 and it blows out to 200 - you can now either hold the position and see if spreads go up, or if there is a credit event; or you can sell the position for a gain). Sell CDS: Why? earn upfront payment and periodic payments from the Long CDS Transaction: Sell CDS contract, receive upfront and periodic premia; forced to deliver predetermined value in case of credit event (again, what defines a credit event? will be in the contract). I hope this was helpful, it was as much helping clarify as helping me remember all of this
bump. i thot i know this, but actually i don’t. very good summ
James - only just followed this thread up. thanks for your explanation - much clearer now!
To protect an asset against credit risk, there are basically these choices: If you are concerned about the credit event (downgrade, or default) Buy binary credit puts (the underlying is the asset’s price, which will decrease should the credit even happen) Get into a credit default swap If you are concerned about changes in credit spread Buy credit spread calls (the underlying is the credit spread, which will increase if credit risk goes up) Buy credit spread forwards The credit even instruments are contingent on credit event; the spread instruments are not. that is it!