Funds Investing

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 Read the rest of this entry »

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. Read the rest of this entry »

A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the total return realized on a reference obligation or a basket of reference obligations. A total return payment includes all cash flows that flow from the reference obligations as well as the capital appreciation or depreciation of those reference obligations. When the reference obligation is a bond market index, the swap is referred to as a total return index swap.

The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver; the party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.

Notice that in a total return swap, the total return receiver is exposed to both credit risk and interest-rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates. Read the rest of this entry »

An investor who lends funds by purchasing a bond issue is exposed to three types of credit risk: (1) default risk, (2) credit spread risk, and (3) downgrade risk.

Traditionally, credit risk is defined as the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. This form of credit risk is called default risk. If a default does occur, this does not mean the investor loses the entire amount invested because the investor can expect to recover a portion of the investment. Read the rest of this entry »