Credit derivatives

[Eveline]

Hi David,

Can you help me with this please?

Your firm is holding a short position in an Argentinean bond with a notional value of ARS 5,000,000 and a coupon yield of 5.5%. Your model predicts the bond's yield will decrease over the coming year. You are asked to hedge the position. Your recommendation is to:
a) Buy a credit default swap
b) Sell a credit-spread put option
c) Short a credit-spread forward
d) Buy a total rate of return swap

Ans: b

Thanks a lot!

 

[David Harper CFA FRM]

Hi Eveline

It's handy to think of a risky bond yield as = riskfree + spread, so y = r+s

a) In regard to the CDS, bond yield may decrease "merely" because the riskfree rate decreases (i.e., a shift in term structure due to, for example, a flight to quality). This is an example of market risk and the CDS won't hedge here.
Question for you: what if yield decreases because the spread decreases, will CDS hedge?

b) credit spread put payoff = duration * notional * max(0, credit spread - strike spread)
the writer here has an income strategy: hopes the credit spread narrows and put expires
some authors (and the question apparently) call this a "hedge;" I disagree....i don't think this is a hedge...in the same way i don't consider writing a covered call to be a hedge strategy but rather an income strategy

c) credit spread forward = duration * Notional * (strike spread - credit spread); i.e., short pays this to the long
...if spread decreses, yield decreases, and short pays the long
...so the hedge here is the opposite: should buy the forward

d) The TROR is best protection, this is the hedge;
But I don't like "buyer" terminology for TROR. If question means TROR receiver (investor) then this isn't the hedge
But TROR payer is the hedge (i.e., transfers credit & market risk to receiver)

So I get (d) not (b)

David