Put structures will provide investors with some protection in the event interest rates rise sharply, but not if the issuer has an unexpected credit event.
Why this statement is incorrect???
If the issuer has an unexpected (presumably negative) credit event, the spread will increase, so the bond price will decrease; a put is valuable in that case.
Well, because it WILL provide protection in the case of a credit event. An unexpected credit event would cause the bond price to drop just like interest rates rising.
But what if the issuer lose the ability to repay the loan? Then the put opion will be invalid, right?
That’s the whole point behind the put option. You put it on someone else with a strike price. The seller of the put has an _ obligation _ to buy it. If the put seller is another counter-party, then he will recieve a defaulted bond.
What you don’t say here is who is the counterparty of the put. Usually in this case it’s the issuer of the bond himself. He issues a bond and provides you with an option on it at the same time.
You will want to exercise your put when the value of the bond decreases. For example when interest rates rise. Pretty easy so far.
If this issuer faces an unexpected credit event, the bond value will also decrease which is usually when you will want to exercise your put. But not in this case because the whole point of the credit event is that the issuer (the counterparty of your put option) is not able to redeem the bond. So it does not protect you in this case.
I guess that depends. If the company can be sold to a strategic investor (including itself) at a higher price than it’s break-up value, then the company may deliver the short put rights. If it’s a strategic default, then they might as well default on that too.
Haha well here you are enlarging the topic to further areas! Coming up with big scenarios is for CFA level IV 