UNDERLYING IS A CREDIT SPREAD ON A REFERENCE OBLIGATION

When the underlying for a credit spread option is the credit spread for a reference obligation over a referenced benchmark, then the payoff of a call and a put option are as follows:

Credit spread call option:

payoff =

(credit spread at exercise — strike credit spread) x notional amount x risk factor

Credit spread put option:

payoff =

(strike credit spread — credit spread at exercise) x notional amount x risk factor

The strike credit spread (in decimal form) is fixed at the outset of the option. The credit spread at exercise (in decimal form) is the credit spread over a referenced benchmark at the exercise date.

The risk factor is equal to

risk factor = 10,000 x percentage price change for 1-basis-point change in rates for the reference obligation

FundsBy including the risk factor, this form of credit spread option overcomes the problem we identified with the credit spread option in which the underlying is a reference obligation: The payoff depends on both changes in the level of interest rates (the yield on the referenced benchmark) and the credit spread. Instead, it is only dependent upon the change in the credit spread. Therefore, fluctuations in the level of the referenced benchmark’s interest rate will not affect the value of these credit spread options.

Notice that when the underlying for the credit spread option is the credit spread for a reference obligation over a referenced benchmark, a credit spread call option is used to protect against an increase in the credit spread. In contrast, when the underlying for the credit spread option is the reference obligation, a credit spread put option is used to protect against an increase in the credit spread.

To illustrate the payoff, suppose that the current credit spread for a credit spread call option is 300 basis points and the investor wants to protect against a spread widening to more than 350 basis points. Accordingly, suppose that a strike credit spread of 350 basis points is selected. Assuming that the risk factor is 5 and the notional amount is $10 million, then the payoff for this option is

payoff = (credit spread at exercise — 0.035) x $10,000,000 x 5

If at the exercise date the credit spread is 450 basis points, then the payoff is

payoff = (0.045 — 0.035) x $10,000,000 x 5 = $500,000

The profit realized from this option is $500,000 less the cost of the option.

Credit Spread Forwards

A credit spread forward requires an exchange of payments at the settlement date based on a credit spread. As with a credit spread option, the underlying can be the value of the reference obligation or the credit spread. The payoff depends on the credit spread at the settlement date of the contract. The payoff is positive (i.e., the party receives cash) if the credit spread moves in favor of the party at the settlement date. The party makes a payment if the credit spread moves against the party at the settlement date.

For example, suppose that a manager has a view that the credit spread will increase (i.e., widen) to more than the current 250 basis points in one year for a reference obligation. Then the payoff function for this credit spread forward contract would be

(credit spread at settlement date — 250) x notional amount x risk factor

Assuming that the notional amount is $10 million and the risk factor is 5, and the credit spread at the settlement date is 350 basis points, then the amount that will be received by the portfolio manager is

(0.035 — 0.025) x $10,000,000 x 5 = $500,000

Instead, suppose that the credit spread at the settlement date decreased to 190 basis points. The portfolio manager would then have to pay out $300,000 as shown below:

(0.019 — 0.025) x $10,000,000 x 5 = —$300,000

In general, if a portfolio manager takes a position in a credit spread forward contract to benefit from an increase in the credit spread, then the payoff would be as follows:

(credit spread at settlement date — credit spread in contract)
x notional amount x risk factor

For a portfolio manager taking a position that the credit spread will decrease, the payoff is

(credit spread in contract — credit spread at settlement date)
x notional amount x risk factor

Possibly related posts: (automatically generated)
Credit Spread Options Part 2