Credit spread options

Credit spread options allow investors to trade or hedge changes in credit quality.
With a credit spread option, a protection seller takes the risk that the spread on a
reference asset breaches a specified level. The protection purchaser buys the right
to sell a security if the reference obligor’s credit spread exceeds a given ‘strike’ level.
For example, assume a bank has placed a loan yielding LIBOR plus 15 basis points
in its trading account. The bank may purchase an option on the borrower’s spread
to hedge against trading losses should the borrower’s credit deteriorate. The bank
may purchase an option, with a strike spread of 30 basis points, allowing it to sell
the asset should the borrower’s current market spread rise to 30 basis points (or
more) over the floating rate over the next month. If the borrower’s spread rises to 50
basis points, the bank would sell the asset to its counterparty, at a price corresponding
to LIBOR plus 30 basis points. While the bank is exposed to the first 15 basis
point movement in the spread, it does have market value (and thus default) protection
on the credit after absorbing the first 15 basis points of spread widening. The seller
of the option might be motivated by the view that a spread of LIBOR plus 30 basis
points is an attractive price for originating the credit exposure.
Unlike other credit derivative products, the US market for credit spread options
currently is not significant; most activity in this product is in Europe. Until recently,
current market spreads had been so narrow in the USA that investors appeared
reluctant to sell protection against widening. Moreover, for dealers, hedging exposure
on credit spread options is difficult, because rebalancing costs can be very high.
Table 11.2 summarizes some of the key points discussed for the four credit derivative
products.