Quick Question - PLEASE HELP - FLATTENING CREDIT CURVE

CFA Level II Fixed Income
#1

Statement 2
“Our analysts expect that the credit curve for Company A will flatten, whereas the credit curve for Company B is expected to steepen.”

Kumar responds, as follows: “A trade that addresses Statement 2 would be to sell Company A CDSs with a 10-year tenor and buy Company A CDSs with a 5-year tenor. Alternatively, one could buy Company B CDSs with a 10-year tenor and sell Company B CDSs with a 5-year tenor.”

Is Kumar’s response to Statement 2 by Petsas most likely correct?

  1. Yes.
  2. No, she is incorrect about the trade involving Company A CDSs.
  3. No, she is incorrect about the trade involving Company B CDSs.

Solution

A is correct.

My Question: How is A correct? What if the 10 yr spreads for company A decline to the 5 yr spreads to make the credit curve flat? Then why wouldn’t you just sell the 10 yr spreads and do nothing with the 5 yr spreads? And if its the other way around, the 5 year spreads rise to the 10 year spreads, you would just buy CDS on the 5 year CDSs and do nothing with the 10 year CDSs?

#2

Because that wasn’t an option.

You aren’t being asked for the best strategy. You’re being asked whether the strategies presented are appropriate or not.

1 Like