So maybe I’m thicker than usual today, but I don’t understand why the buyer of a credit forward gets paid when spreads widen. If you buy an asset forward don’t you benefit when the asset appreciates above your contracted purchase price? In the case of spreads, this would be represented by a narrowing of the spread vs. the fwd spread that was contracted.
Any thoughts?
spread = yield on your bond - yield on treasury.
when spreads widen – usually the yield on your bond is going UP – bond price is going down – so credit quality is deteriorating… so BUYER of the forward gets paid on the forward contract.
if spread narrows - price of your bond is going up - because the yield on your bond is falling …
But why get paid? You’ve committed to buy a spread product, say at 100bps and at maturity, it trades at 200bps, so it has cheapened and you’re overpaying the asset. I don’t get how come you’re supposed to come on top economically speaking. Seems the SELLER should profit from this trade.
You haven’t committed to buy anything…credit forwards are cash settled so that when spreads widen, meaning the credit quality of the bond has deteriorated (and therefore the bond price is falling) you get paid more cash from the seller of the credit forward at settlement.
The holder of the forward’s payoff is positively related to the difference between the agreed upon spread at the start (the “price”) and the terminal spread of a particular credit risky bond.
This extra cash from the widening of spreads works to offset the loss if you are holding the bonds.
So I guess what I should take away, is that it’s just a form of put…that’s being called a forward.
No it’s not equivilant to a put, as it doesn’t have an asymetric payoff like a put does. It is a forward, so has a symetric payoff.
Say the current credit spread is 100 basis points, and you enter into a credit forward at a “price” of 100. That is for each basis point the spread tightens, i.e. falls below 100 - then you owe the seller of the forward…and for each basis point the spread widens i.e. rises above 100, the forward seller owes you.
A notional value is set for the contract so that the ending cash payout is the number of basis point above or below the starting “price” that the spread ends up, multiplied by the notional value attached to the forward.
One could enter into this long forward contract as a hedge to being long the bonds of the company who’s credit spread is the basis for the forward contract.
If you own the bonds and the credit spread widens, obviously this means the price of the bonds has fallen and you have lost out there.
But at the same time you lose out on holding the bonds, being long the credit forward means you are compensated for the widening spreads (falling bond prices).
Right so it’s like a buying a put and writing a call at the same strike price then (assuming offsetting premiums)
In any event, I get the whole logic, it just interferes with my traditional understanding of buying a forward. For instance, I’m used to understand hedging as taking a position in the scenario you don’t want to happen. In that case, that adverse scenario is spread widening so you would be short the spread forward. If the spread widens, you lose on the position but gain on the forward because you can now buy the product at the wider spread (i.e. cheaper) and sell it at the tighter spread you contracted. The profit on the forward will then offset the loss on your cash position. If you messed up and the spread narrows, you’re purchasing the product at a tighter spread and contractually selling it back at a higher one. Whatever you made on your existing position is offset by that loss, so it’s symmetric. The whole issue is that my logic has the sale of the spread product forward accomplishing that protection, whereas it is rather described that one must be a buyer of the credit forward.
Since I’m studying for the CFA level 3 exam and I don’t intend on failing it, I will play nice on the exam and simply retain that in the very specific case of forwards, buying a credit forward is what one does to protect against widening and that it’s symmetric.And since we had that discussion, I will most likely remember that on the exam, so thank you very much!
I think you get the general logic - but remember, when buying a spread forward you don’t HAVE to have the underlying bond position. I just used that in my example as that is often the postion that you want to hedge while using a spread forward.
You could however just take a speculative position in a spread forward if you predict a widening of the spread.
I know that often time when you enter into a future/forward, it is a promise to buy some underlying asset at a specified price at a specified future date.
But with a spread forward there is no “investable” underlying - that is there is no actual asset to buy or sell. You can’t buy and “own” a credit spread - it is just a number measured in basis points.
So credit spreads are probably best seen more like “contracts for difference” - the underlying is just a number - you are “long” that number if you are long the forward. If the spread ends up higher than the “price” you bought the future at, you gain - if it ends up lower you lose.
"So credit spreads are probably best seen more like “contracts for difference” "
Bingo! Thanks for your help!