Credit Spread Option
In the financial world, a credit spread option (also known as a "credit spread") is an options contract that includes the purchase of one option and the sale of a second similar option with a different strike price. 1:19 The buyer of a credit spread option can receive cash flows if the credit spread between two specific benchmarks widens or narrows, depending upon the way the option is written. The buyer of the credit spread option (call) assumes all or a portion of the risk of default and will pay the option seller if the spread between the company's debt and a benchmark level (such as LIBOR) grows. A credit spread option is a type of strategy involving the purchase of one option and the sale of a second option. In this scenario, there is a risk that the particular credit will increase, causing the spread to widen, which then reduces the price of the credit.
What Is a Credit Spread Option?
In the financial world, a credit spread option (also known as a "credit spread") is an options contract that includes the purchase of one option and the sale of a second similar option with a different strike price. Effectively, by exchanging two options of the same class and expiration, this strategy transfers credit risk from one party to another. In this scenario, there is a risk that the particular credit will increase, causing the spread to widen, which then reduces the price of the credit. Spreads and prices move in opposite directions. An initial premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level.
Understanding a Credit Spread Option
The buyer of a credit spread option can receive cash flows if the credit spread between two specific benchmarks widens or narrows, depending upon the way the option is written. Credit spread options come in the form of both calls and puts, allowing both long and short credit positions.
Credit spread options can be issued by holders of a specific company's debt to hedge against the risk of a negative credit event. The buyer of the credit spread option (call) assumes all or a portion of the risk of default and will pay the option seller if the spread between the company's debt and a benchmark level (such as LIBOR) grows.
Options and other derivatives based on credit spreads are vital tools for managing the risks associated with lower-rated bonds and debt.
Related terms:
Benchmark
A benchmark is a standard against which the performance of a security, mutual fund or investment manager can be measured. read more
Cash Flow
Cash flow is the net amount of cash and cash equivalents being transferred into and out of a business. read more
Compound Option
A compound option is an option for which the underlying asset is another option, thus two strike prices and two exercise dates. read more
Credit Risk
Credit risk is the possibility of loss due to a borrower's defaulting on a loan or not meeting contractual obligations. read more
Credit Spread , Formula, & Examples
A credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. It also refers to an options strategy. read more
Derivative
A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset. read more
Forward Start Option
A forward start option is an exotic option that is bought and paid for now but becomes active later with a strike price determined at that time. read more
Hedge
A hedge is a type of investment that is intended to reduce the risk of adverse price movements in an asset. read more
Leg
A leg is one component of a derivatives trading strategy in which a trader combines multiple options contracts or multiple futures contracts. read more
Non-Equity Option
A non-equity option is a derivative contract with an underlying asset of instruments other than equities. read more