Reference question, Schweser Pratice exam Volume 2, Exam 2, morning Session, number 7C, part i. A bond is trading at 250bps above its comparable T-bond, manager wants to protect himself from any increase of spread over 250bps, so he enter into a credit spread forward to protect himself. What is the max loss the manager can incurr? Well, the answer assume that the spread at maurity of the credit spread could be 0, therefore the max loss is (0-2.5%) X Notional Amount X risk factor. Here is my question, therotically, can it be the max loss be (-yield on t-bond minus 2.5%) X Principle Amount X Risk Facotor? I am assuming that the yield on the bond drops to 0%(don’t know how, but just in theory) Example, my bond is trading at 8.5%, T-Bond is Tradeing at 6%. According to Schweser, at maturity, the my bond is trading at 6%, so it has 0% spread over T-Bond; what if for some reason, my bond is trading at 4.5% (due to whatever reason), the spread will become -1.5%(can you have negative spread)? So, the loss for the manager is (-1.5%-2.5%) X Principel Amount X Risk Factor. If my bond is yielding @ 0%, then the spread will be 0%-6%=-6%, that is how I used (-yield) in my above equation. Am I right aruging that? Or I am completely wrong? Thanks
unless your bond becomes risk free, it can’t have a negative spread to the appropriate t bond…and if it becomes risk free, it would exhibit the same yeild as the appropriate t bond… so you are completely wrong, but i mean that in a nice way.
Got it…thanks striker! I felt there was some flaw in my arguments, thanks for letting me know.
oh oh oh, but what if there is an investor who is being affected by: bounded rationality, limited information, and non-fundamental incentives to owning the security? and, what if said investor deals with a CFA charterholder who does not adhere to III. a. Loyalty Prudence and Care and sells the investor a bond at an excessive price such that is not in the best interests of the client? bet you didn’t think about that now did ya??? then again, the investor won’t be sophisticated enough to purchase a credit spread forward contract…