FI Investment Co. (FI) has recently observed an increase in the credit risk of their fixed income portfolios. Management has never used credit derivatives to hedge this risk, but thinks that this might be time to try them. Bill Bales, one of the portfolio managers, is instructed to learn about the basics of credit derivatives and then use them to hedge credit risk in FIs portfolios. First, Bales looks at why investors would sell credit protection. He makes some notes as to why credit protection would be sold: - Sellers are hedging their fixed income positions.
- Sellers may expect a ratings upgrade for the asset/issuer as a likely outcome.
- Sellers may sell credit protection options to enhance portfolio income, assuming the options finish in-the-money.
- Sellers believe that a takeover by another firm is unlikely.
Next, Bales explores the use of binary credit options. He realizes there are quite a few of them. To put them in perspective, he develops a list of binary credit options that might be appropriate for FI portfolios: - A call option that has its value tied to the difference between the market spread and a reference spread and the payoff is an increasing function of the credit spread.
- A put option that allows the holder to put the bond back to the issuer at a fixed-price if the credit rating falls.
- A call option that pays the difference between a reference value and the market value of the bond after a downgrade.
- A call option that pays additional coupon income in the event of a downgrade.
Bales research indicates that not only can credit derivates be used to protect FIs fixed income portfolios from certain types of risks, but they can also be employed to lower the firms borrowing costs. Bales is able to convince FIs CEO Tim Brown to issue the following bond: - A 5-year, annual pay, $20 million bond offering at a rate of LIBOR plus 150 basis points.
- LIBOR is 6.5 percent.
- The bonds will be issued with a credit spread put, with a strike price that is determined by a 200 basis point spread over LIBOR.
- One year from today (t=1) (the day after the coupon payment is made) LIBOR moves to 7 percent and the yield on the bond is at 9.25 percent.
Regarding the sellers of credit protection, which statement is most accurate?
Answer and Explanation
Sellers of credit protection are speculators that are motivated by potential increases in credit quality. They believe in a possible ratings upgrade, takeover, or redemption of outstanding bonds due to the availability of lower cost financing sources.
Regarding a total return credit swap which of the following statements is least accurate? | A) | The swap can hedge many types of risk with a single contract. |
| | B) | The number of transactions can be significantly less than the individual transactions anticipated with trading the underlying. |
| C) | The total return payer owns the underlying assets. |
| | D) | The total return payer receives an amount based on a specified reference at the swaps settlement dates. |
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Answer and Explanation
The total return payer may or may not own the underlying securities. Entering into a credit swap as the total return payer without owning the underlying assets is a way to short a bond. A total return credit swap does hedge many types of risk. Also, the number of transactions will likely be less than trading the underlying, and the total return receiver pays an amount based on a specified reference at the swaps settlement dates.
The investor who buys FIs bond issue holds a $20 million face value position. The value of the put option that FI issued with the bond is closest to which of the following values one year from today? | | B) | the put is out-of-the-money. |
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Answer and Explanation
First, find the value of the bond and the strike price at the new LIBOR and yield to maturity rates, then calculate the option value. Bond: N = 4; I/Y = 9.25; FV = 100; PMT = 8; CPT PV = 95.9725
Strike: N=4; I/Y = LIBOR + 200 = 9; FV = 100; PMT = 8; CPT PV = 96.76028
Option Value = $20,000,000 × [(96.76028 95.9725) / 100] = $157,556 as long as the option is in the money determined by (BYt - RYt) > SS where BYt = 9.25%, RYt = 7%, and SS = 2% thus 9.25 - 7 = 2.25% > 2% and the put option is in the money.
First, find the value of the bond and the strike price at the new LIBOR and yield to maturity rates, then calculate the option value. Bond: N = 4; I/Y = 9.25; FV = 100; PMT = 8; CPT PV = 95.9725
Strike: N=4; I/Y = LIBOR + 200 = 9; FV = 100; PMT = 8; CPT PV = 96.76028
Option Value = $20,000,000 × [(96.76028 95.9725) / 100] = $157,556 as long as the option is in the money determined by (BYt - RYt) > SS where BYt = 9.25%, RYt = 7%, and SS = 2% thus 9.25 - 7 = 2.25% > 2% and the put option is in the money. First, find the value of the bond and the strike price at the new LIBOR and yield to maturity rates, then calculate the option value. Bond: N = 4; I/Y = 9.25; FV = 100; PMT = 8; CPT PV = 95.9725
Strike: N=4; I/Y = LIBOR + 200 = 9; FV = 100; PMT = 8; CPT PV = 96.76028
Option Value = $20,000,000 × [(96.76028 95.9725) / 100] = $157,556 as long as the option is in the money determined by (BYt - RYt) > SS where BYt = 9.25%, RYt = 7%, and SS = 2% thus 9.25 - 7 = 2.25% > 2% and the put option is in the money.
Assume that instead of a credit put option, FI intends to issue the bond with a credit call option. The bonds risk factor is 2 and assume it is now one year from today. The value of the credit call option is closest to: | | | | D) | the credit call is out-of-the-money. |
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Answer and Explanation
The value of the credit call is equal to the actual spread over the benchmark versus the specified spread over the benchmark times the principal times the risk factor.
Note that the payoff is not binary the payoff to the option will increase as the spread over the benchmark gets larger. (0.0925 0.0700 0.0200) × $20,000,000 × 2 = $100,000
The value of the credit call is equal to the actual spread over the benchmark versus the specified spread over the benchmark times the principal times the risk factor.
Note that the payoff is not binary the payoff to the option will increase as the spread over the benchmark gets larger. (0.0925 0.0700 0.0200) × $20,000,000 × 2 = $100,000
The value of the credit call is equal to the actual spread over the benchmark versus the specified spread over the benchmark times the principal times the risk factor.
Note that the payoff is not binary the payoff to the option will increase as the spread over the benchmark gets larger. (0.0925 0.0700 0.0200) × $20,000,000 × 2 = $100,000
With regards to the binary credit options, which of the statements given are least accurate?
Answer and Explanation
The key to a binary option is that it assumes one of two possible states. The option either pays or does not pay. The value does not continue to rise (or fall) based on the value of the underlying. Thus, a call that has a payoff as an increasing function of the credit spread would not be binary.
FI holds a large position with a 10-year maturity. Recently, Bales has observed a significant increase in the spread relative to the 10-year Treasury. Today he learns that Moodys has changed the rating on the bond from investment grade to speculative. In terms of credit risk, FI is dealing with: | A) | credit spread, default and downgrade risk. Credit spread risk can be managed with credit options and credit forwards. Downgrade risk can be managed with either credit forwards or swaps. Default risk can only be managed with swaps. |
| | B) | credit spread and default risk. Credit spread risk can be managed with credit options and credit forwards. Default risk can be managed with credit forwards, swaps, and credit options. |
| C) | credit spread and downgrade risk. Credit spread risk can be managed with credit spread options, credit spread forwards, and total return swaps. Downgrade risk can be managed with credit options, credit swaps, and total return swaps. |
| | D) | downgrade risk only. Downgrade risk can be managed only with credit forwards and swaps. |
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Answer and Explanation
These are examples of credit spread and downgrade risks. Credit spread risk is the risk that the yield premium over the relevant risk free benchmark will increase. Downgrade risk reflects the possibility that the credit rating of an asset/issuer is downgraded by a major credit-rating organization. The investor can use credit spread options, credit spread forwards, or total return swaps to manage credit spread risk. Credit options, credit swaps, and total return swaps can be used to manage downgrade risk. [此贴子已经被作者于2008-9-15 15:49:03编辑过] | 
发表于 2008-9-15 15:43
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