HEDGING OR NO HEDGING

[aditya]

hi david,


1) In credit spread call option
the payoff is : NP * duration * max [ (strike spread - credit spread(t) ) , 0]
so when credit spread falls imples bond prices increase this gives a payoff from the option

it is being said that this option creates a hedge against a short position in a bond.


2) in credit spread forward
the payoff is same as this is not an option so instead of srike spread there is inception spread

it is being said that buyer has created a long position in bond

i understand the terminology for why these positions are being created but how do we know that hedging is present or not ,like in (1
) we could have said that buyer of cs put option creates a long position in bond.like from where all of the sudden hedging comes in the picture. is there anything i m missing.

plz also tell what is credit spread swap??

i request u to plz clarify.

thanx
adi

 

[David Harper CFA FRM]

Adi,

Hedging implies two instruments: the underyling (e.g., the original bond) and, additionally, a hedge instrument (e.g., credit spread option or credit spread forward).

So, to start, neither are necessarily hedges. But in combination with owning a bond, either/both may be a hedge.

In the case of your credit spread call option:
Without any underlying reference (i.e., no hedge), as this profits on a bond price increase, this is to be SYNTHETICALLY LONG the bond.
Now if you are short the bond, it can as an additional position, provide a HEDGE against the short.

In the case of your credit spread forward:
Without any underling, to be long the forward is to be SYNTHETICALLY LONG the bond (profit like owning but without owning)
Now if you are short the bond, the same forward can be a HEDGE (it's a hedge if you have two instruments)

Re credit spread swap: it is like an interest rate swap, except the fixed-payer/recieve-floating is paying a credit spread instead of a fixed coupon rate

David