Credit Spread options
Mar 31, 2005
Team Latte

A hedge fund is long a high yield emerging market bond to the amount of $50 million. The bond, which is currently yielding 8%, is trading at $68.06. The bond has another 5 years to mature. The comparable 5 year U.S. Treasury is yielding 4% and trading at $82.20.

The hedge fund believes that there would be a major economic recovery in the country and hence credit spreads will decrease further. The fund manager has been advised by his resident quant that the annualized historical volatility of the spread is around 60% whereas as the implied volatility is 110% as quoted by a few market makers in the OTC spread options market. The fund manager wants to take a one year exposure on the credit quality of the bond but does not want to add to his cash long position in the bond. The duration of the bond is 4.67.

The quant and the manager agree that the implied volatility of the spread is too high and it should come down significantly in a year's time, given their view that there would be a significant improvement in the credit quality of the bond because of macroeconomic and company specific factors. It would be a great opportunity to enhance the return of the fund should the view prove to be correct.

The manager therefore sells an at the money, ATM (cash settled) credit spread put option on the reference asset (bond) for a notional amount of $100 million. The Manager invests the proceeds from the sale of the option into 5 year US Treasuries.

1. What is the cost of buying ATM credit spread put options?
2. What is the delta and the gamma of the spread put option?
3. What is the fund manager's net long position?
4. Is there an alternative strategy or trade that the manager should have considered to gain exposure to the improving credit quality of the bond?
5. Analyze the risk profile of the portfolio.

After six months there is a further downgrade of the bond by a major rating agency and also a downgrade of the country's credit rating. The yield on the bond goes up to 9.5% and the 5 year US Treasury yields fall to 3.5% due to a rate cut in the U.S.

1. How will this affect the manager's portfolio?
2. What happens to the manager's 99% 10-Day VaR?

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