Reading 23, practice problem 4 says: Current credit spread on bonds issued by Great Foods is 300bps. Manager of More Money Funds believes that Great Foods’ credit situation will improve resulting in a smaller credit spread on its bonds. She decides to enter into a six-month credit spread forward contract taking the position that the credit spread will decrease. Does this mean she has sold the credit spread forward? Because the answer says if at settlement date 6 months later the credit spread is 250bps, her gain = 0.03-0.025 x 10m notional x risk factor 5 = gain of 250,000
As a general rule, the long position in a forward contract gains when the underlying (whatever it is) increases: price of oil, interest rates, credit spreads, whatever. The short position gains when the underlying decreases.
I don’t know of a forward contract for which this isn’t true, so it’s a easy rule of thumb.
Does this mean she has sold the credit spread forward? : Yes.
Justification : 1.The underlying asset of the credit spread forward : credit spread 2.Her expectation : the credit spread will decrease (underlying asset value will decrease) 3.Thus, she must take a short position of the credit spread forward contract
Roy Kim… we are in the world of derivatives. However the asset value(underlying) actually increases here.
As you know, I know that (in the real world) But I just reply for johntavv’s question. Thank you for your interest and understanding.
Can check that the answer for this qn: A. Payoff = (0.030 − 0.025) × $10 million × 5 = $250,000.
Why isit that there’s no need to take into account “six-month” credit spread by multiplying by 0.5?
because it’s just asking for the return during that period. and none of the information it provided was annualized.