On page 117 book 4 example 14 # 3 & 4 it asks should an investor buy a credit spread put or call if they anticipate widening credit spread. Although I can’t find it in the book, I researched that credit spread put benefits when spreads widen and credit spread call benfits when spreads tighten.
www.youtube.com/watch?v=altg-wl0ZdQ
The answer indicates the exact opposit.
Credit spread calls have a positive payoff when the actual credit spread exceeds the strike spread; credit spread puts have a positive payoff when the strike spread exceeds the actual credit spread.
If an investor anticipates a credit spread widening, he wants to buy credit spread calls.
If you think of a credit spread as if it were the price of an asset, then you’ll always get this right: you want to buy calls when you think prices are rising, and you want to buy puts when you think prices are falling.
Thanks for the answer S2000. Still a little confused.
If you feel credit spreads are going to widen then the price of an asset will decrease, right? More simply shouldn’t you follow the below rational.
So if you believe spreads are going to widen (interest rates going up) you’d buy a interest rate put. (From my point of view).
My pleasure.
We’ll fix that.
Correct.
No, you shouldn’t.
I believe that you are confusing the payoff on credit spread options with the payoff on asset price options. As you say, when interest rates increase (as when spreads widen), asset prices decrease. Thus, to hedge the loss when the spread widens and the asset price decreases, you want either:
put options on the asset price (which are in the money when the price drops), or
call options on the credit spread (which are in the money when the spread widens).
Great thanks for your reply. My confusion lies with the credit spread formula for calls vs. puts which I don’t believe is in the required readings. From outside sources (dangerous I know) which is the Bionic Turtle link I posted, it says:
Credit Spread Put = Duration * Notional * Max(Credit Spread - Strike Spread)
Credit Spread Call = Duration * Notional * Max (Strike Spread - Credit Spread)
This is opposite to what you posted. Is there anywhere in the required readings which details whether spread widening benefits call or put options? Again thanks.
I don’t have the CFA Institute books, but in the SchweserNotes, book 3, p. 85 they show the payoff on a credit spread call option. That section covers Reading 25, so you might look there.
Thanks! That helps a ton.
My pleasure.
