Credit Spread Option

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Credit Spread Option

What Is a Credit Spread Option?

A credit spread option (sometimes known as a “credit spread”) is a financial option contract that consists of the purchase of one option and the selling of a second comparable option with a different strike price. This method effectively transfers credit risk from one party to another by swapping two options of the same class and expiry. In this case, there is a possibility that the price of the credit may rise, causing the spread to widen and so lowering the price of the credit. Prices and spreads move in opposing directions. The buyer pays an initial premium in return for anticipated cash flows if a specific credit spread changes from its existing level.

Credit Spread

Understanding a Credit Spread Option

Depending on how the option is constructed, the buyer of a credit spread option may get cash flows if the credit spread between two particular benchmarks increases or narrows. Credit spread options are available as calls and puts, enabling for both long and short credit positions.

Key Takeaways

  • A credit spread option is a technique that involves the purchase of one option and the selling of another.
  • The two credit spread strategy options have the same class and expiry date but differ in terms of strike price.
  • When an investor takes the position, he earns a net credit; if the spread narrows, the approach pays out.

Holders of a certain company’s debt may issue credit spread options to hedge against the chance of a bad credit event. The buyer of the credit spread option (call) bears all or part of the default risk and agrees to pay the option seller if the gap between the company’s debt and a benchmark level (such as LIBOR) widens.

  Default Risk vs. Credit Spread Risk

Credit spread options and other derivatives are critical instruments for controlling the risks associated with lower-rated bonds and debt.

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