15
Spread Options, Callable/Puttable Bonds, Callable Asset Swaps, Callable Default Swaps
The biggest problem with spread option products is the lack of an open market and of any source of ‘implied’ spread volatility. This may be changing in the portfolio area - with the introduction of options in the iTraxx CDO tranches - but single name spread options remain a narrow market, and are largely restricted to embedded ‘conservatively’ priced options.

15.1 PRODUCT DEFINITIONS

15.1.1 Vanilla Spread Options and Variations

A credit-spread option is an option on the spread of a ‘defaultable’ bond (e.g. the yield on Fiat 5.75, May 2014) over a reference yield (e.g. the interpolated EURIBOR swap rate). At maturity (European), or at any time up to maturity (American), a credit-spread put (call) gives the buyer the right but not the obligation to sell (buy) the defaultable bond at the price implied by the strike-spread and the reference yield. For example, the bond may be trading at 150 bp currently, the option may be a European put exercisable in one year’s time at a z-spread of 250 bp. The holder of the bond may also hedge the fixed coupons with an interest rate swap, thus interest rate moves have equal and opposite impacts on the bond and swap. If spreads on the bond rise to 400 bp in a year’s time, then the bond plus interest rate swap value will decline below the initial price. Instead of selling the bond at a 400 bp spread, the option buyer can sell at 250 bp through the option, ...

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