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Category: Risk Management in Banking

Credit spread derivatives refer to the credit spread relative to the risk-free benchmark or differentials of credit spreads of two risky assets. In addition, there are credit spread forwards and credit spread options. The specifics of credit spread derivatives is that they isolate the effect of spreads as opposed to contracts on prices subject to the entire yield change combining both interest rate variations and spread variations. Spread products are similar to other derivatives. Credit swaps exchange credit spreads, while credit spread options provide the right to buy a future credit spread, as do other forward and option contracts. The difference is that the underlying is a credit spread. The value of a spread variation depends on the duration of the underlying assets.

The seller of a credit spread swap pays the buyer a predetermined fixed spread, while the buyer pays the seller the spread of a risky asset over the risk-free rate, or another security. The buyer is insensitive to spread variations of the reference assets since he gets the fixed spread anyway. The seller gains if the risky spread widens and suffers a loss if the risky spread narrows.

There is a potential for heterogeneous expectations and discrepancies between spreads derived from todays yield curves and tomorrows credit standing materialized in future spreads. Spread derivatives serve to trade, hedge or arbitrage expectations and market spreads. The buyer of a forward spread bets that credit deterioration or default will occur before the maturity of the contract. The seller of a forward spread hopes the opposite will occur (Figure 58.4).

Forward contracts on interest rates are similar, except that such contracts have exposure to interest rate risk, not spread. Locking in a forward rate as of today implies lending long and borrowing short. To isolate the spread effect, it is necessary to sell forward the risky debt and buy forward the risk-free debt. Since the price variations due to yield changes are duration-driven, it is necessary to adjust the amounts to compensate any duration mismatch. The remaining change in price is due to spread variations. Forward contracts on spreads use current spot prices, just as forward rates are implicit in spot rates.

Credit spread options are options whose payoff depends on the spread between a risky bond and a risk-free bond. Cash transactions do not disentangle the price variations due to interest rate variations from spread variations. A put on a risky debt does not sell the spread only because its value depends on both interest rate and spread risk. This is a protection against a fall in the price of the asset without risk if the yield, inclusive of the spread, moves in the opposite direction. Only credit spread options strip the risks and isolate the spread risk. Credit spread options have the usual value drivers: notional, maturity, underlying, strike spread and premium. Duration is important because it measures the sensitivity to a credit spread change.

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