Manage Credit Risk

Types of credit risk:

1. Default risk
2. Credit spread risk
3. Downgrade risk

Credit Options

Binary: Payoff based on underlying asset price

Credit Spread Options: based on yield spread

(ref: Interest rate option is different and is dealing with underlyings)

Binary Credit Option: Credit Event (e.g. downgrade) occurs and in the money!

Credit Spread Option value:

Max(0, (actual spread – strike spread)*NP*riskfactor)

Credit forward (“Commodity” is the spread)

FV = (spread at maturity – contract spread) * NP * risk factor

Credit Swap:

e.g. Credit Default Swap (CDS)

Protection premium paid at the beginning of the period

Only get protection when credit events are triggered