Credit Spread Derivatives and Credit Default Hedging

[Liming]

Dear David,
I’ve had some confusion, misunderstanding and doubts when doing 09 Level II Annotated Power Practice. Appreciate your kind help on this!

In your answer to the added question 10d under question 10, you mentioned that tactics to transfer credit risks include: long a credit spread put and enter into a credit spread swap as Payer. Can I just confirm with you that these two derivatives can hedge against default risk?

Thank you for your enlightenment and correction!
Cheers
Liming
16/11/09

 

[David Harper CFA FRM]

Hi Liming,

I just checked Meissner and he confirms (p 38) these do indeed hedge against default risk.

It's a good question because I see that you are distinguishing between credit risk and default risk; i.e., credit risk is the general bucket that includes default risk, deterioration risk, and (rating) migration risk.

So, with the credit spread put and credit spread swap, they are more "hedge encompassing" than the CDS: they hedge against default risk and deterioriation risk (whereas the CDS only hedges against deterioration if M2M).

Thanks, David