A credit spread option is an option whose value/payoff depends on the change in credit spread for a reference obligation. It is critical in discussing credit spread options to define what the underlying is. The underlining can be either

  1. a reference obligation, which is a credit-risky bond with a fixed credit spread, or
  2. the level of the credit spread for a reference obligation

UNDERLYING IS A REFERENCE OBLIGATION WITH A FIXED CREDIT SPREAD

When the underlying is a reference obligation with a fixed credit spread, then a credit spread option is defined as follows:

Credit spread put option: An option that grants the option buyer the right, but not the obligation, to sell a reference obligation at a price that is determined by a strike credit spread over a referenced benchmark.

Credit spread call option: An option that grants the option buyer the right, but not the obligation, to buy a reference obligation at a price that is determined by a strike credit spread over a referenced benchmark.

FundsA credit spread option can have any exercise style: European (exercisable only at the expiration date), American (exercisable at any time prior to and including the exercise date), or Bermuda (exercisable only on specified dates).

The price for the reference obligation (i.e., the credit-risky bond) is determined by specifying a strike credit spread over the referenced benchmark, typically a default- free government security. For example, suppose that the reference obligation is an 8% 10-year bond selling to yield 8`)/0. The price of this bond is 100. Suppose further that the referenced benchmark is a same-maturity U.S. Treasury bond that is selling to yield 6%. Then the current credit spread is 200 basis points. Assume that a strike credit spread of 300 basis points is specified and that the option expires in six months. At the end of six months, suppose that the 9.5-year Treasury rate is 6.5%. Since the strike credit spread is 300 basis points, then the yield used to compute the strike price for the reference obligation is 9.5% (the Treasury rate of 6.5% plus the strike credit spread of 300 basis points). The price of a 9.5-year 8% coupon bond selling to yield 9.5% is $90.75 per $100 par value.

The payoff at the expiration date would then depend on the market price for the reference obligation. For example, suppose that at the end of six months, the reference obligation is trading at 82.59. This is a yield of 11% and therefore a credit spread of 450 basis points over the 9.5-year Treasury yield of 6.5%. For a credit spread put option, the buyer can sell the reference obligation selling at 82.59 for the strike price of 90.75. The payoff from exercising is 8.16. This payoff is reduced by the cost of the option. For a credit spread call option, the buyer will not exercise the option and will allow it to expire worthless. There is a loss equal to the cost of the option.

There is one problem with using a credit spread option in which the underlying is a reference obligation with a fixed credit spread. The payoff is dependent upon the value of the reference obligation’s price, which is affected by both the change in the level of the interest rates (as measured by the referenced benchmark) and the change in the credit spread. For example, suppose in our illustration that the 9.5-year Treasury rate at the exercise date is 4.5% (instead of 6.5%) and the credit -spread increases to 450 basis points. This means that the reference obligation is trading at 9% (4.5% plus 450 basis points). Since it is an 8% coupon bond with 9.5 years to maturity selling at 9%, the price is 93.70. In this case, the credit spread put option would have a payoff of zero because the price of the reference obligation is 93.70 and the strike price is 90.74. Thus there was no protection against credit spread risk because interest rates for the referenced benchmark fell enough to offset the increase in the credit spread.

Notice the following payoff before taking into account the option cost when the underlying for the credit spread option is the reference obligation with a fixed credit spread:

Type of Option
Put
Call

Positive Payoff if at Expiration

credit spread at expiration > strike credit spread credit spread at expiration < strike credit spread

Consequently, to protect against credit spread risk, an investor can buy a credit spread put option where the underlying is a reference obligation with a fixed credit spread.

Possibly related posts: (automatically generated)
Credit Spread Options Part 1