Credit Spreads Explained

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Are Debit Spreads Better Than Credit Spreads?

Here are some misconceptions about credit spreads:

  • “One of the many drawbacks of a credit spread is that it will tie up so much capital.”
  • “Selling credit spreads is like picking up pennies in front of a steam roller.”
  • “Credit spreads are different from debit spreads. One has a low probability of success, the other has a high probability of success.”

I hope that after reading this article, some of those misconceptions will be cleared.

The trigger for this article was a conversation I had on Twitter with one of my followers. Here is a snapshot:

Same Probability? You Bet!

The link in my tweet pointed to one of my previous articles where I clearly demonstrated that credit spreads are in fact the same as debit spreads if using the same strikes.

I guess that one picture is better than thousand words, so lets try to visualize the concept.

Lets try to construct a RUT credit spread having

80% probability of success. Using August 2020 expiration and July 10 closing prices, we can do the following trade:

  • Sell Aug. 2020 RUT 1210 call
  • Buy Aug. 2020 RUT 1220 call

The risk profile looks like this:

As we can see, we get $185 credit for this trade, our margin is $815 ($1,000-185) and maximum gain is 22.7% (185/815). The maximum gain is realized if RUT stays below 1210 by August expiration.

As shown in the chart, the breakeven point is 1211.76 and probability of success 79.5%.

Now lets try to construct the same trade with puts. The trade will be:

  • Sell Aug. 2020 RUT 1210 put
  • Buy Aug. 2020 RUT 1220 put

The risk profile looks like this:

In this trade, we are paying $815 and our margin is the same as the debit ($815). The maximum gain is realized if RUT stays below 1210 by August expiration, in which case the put spread will be worth $1,000. The maximum gain? 1000-815=185, so 185/815=22.7%, exactly the same as with the credit spread. As shown in the chart, the breakeven point is 1211.76 and probability of success 79.5% – again, exactly the same as with the credit spread.

There might be some practical reasons to prefer one trade over another. In our example, the credit spread is constructed using OTM (Out Of The Money) options, that tend to be more liquid and have tighter bid/ask. So while “theoretical” prices might be the same, in practice you might get better fills (which means better probability of success) with the credit spread. In addition, OTM options don’t have assignment risk, while ITM options do. That means that you always have to close the ITM spreads before expiration, while with OTM spreads, you can just let them expire. Of course assignment risk is relevant only to American style options. European style options like RUT, SPX etc. can be exercised only at expiration and don’t have assignment risk.

The bottom line:

The trade can be constructed by selling lower strike and buying higher strike. When using calls, we will get a credit. When using puts, we will pay a debit. But if the same strikes are used, this is exactly the same trade. Same risk profile, same maximum gain, same probability of success, same breakeven point.

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    One of the famous areas in finance is about using and modeling credit spreads. Credit spreads are used every day by large financial institutions to price the transactions.

    This is a special article that will explain the famous credit spread risk and will explain how data science can help there.

    If an investor wants to take more risk then it is only natural for the investor to expect to gain higher return. You can invest your money in a local company and buy its corporate bond or you can invest in buying a government bond. Government bonds are less riskier than the local companies. The riskier the company, the higher the yield interest rate it would offer to attract you into buy its product.

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    Let’s assume you have £1000 to invest. You come across two securities with identical time to maturity. The first security is a high rated instrument such as a government bond and the second security is a corporate bond offered by your local high street bank. The government bond will be referred to as the benchmark security.

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    Spread is all about interest rates.

    What Is Credit Spread?

    Now the way plain vanilla bond works is that you lend your money for a period of time and you get timely payments in return. On the time of maturity, you get all of your original money back. The timely (monthly, semi-annually, annually) payments are based on the yield rate that the borrower offers. The borrower of the money is known as the issuer as it is issuing the bond.

    Now you have considered the buy two bonds in the scenario above. Each of these financial institutions would offer the yield rates over a period of time.

    If you were to plot the yield rates of a government bond and a corporate bond for a time then the difference between the two yields will be known as the credit spread.

    • It’s important to note that the maturity of both of the instruments is identical but the credit quality is different.
    • The credit spread is therefore the difference in risk premiums of the instruments with same maturity and different credit quality.

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    Risk Management: Understanding Credit Risk

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    medium.com

    What Are The Different Spread Measures?

    There are a number of spread measures. I am going to briefly outline the common measures:

    1. Yield Spread: It is the difference between the yield to maturity of a risky and the benchmark bond. The maturities of the instruments is the same.
    2. i-Spread: The “i” refers to the mechanism of interpolation. It is the difference between the yield to maturity of a risky and linearly interpolated yield to maturity on the benchmark bond. It is calculated when the maturities of the instruments is not the same.
    3. z-Spread: The z-spread is constructed by adding the basis points on the spot rate of the benchmark curve to get the desired bond price.
    4. CDS Spread: This is the premium of CDS of issuer bond to protect from any of the credit events. CDS spreads are observable in market. Plus, liquid CDS contracts are available in market for a large number of maturities. Hence CDS spreads are commonly used.
    5. Option Adjusted Spread (OAS): If you take the z-Spread and adjust it for the optionality of the options then it becomes OAS.

    What Is Spread’01 In Finance?

    Spread’01 is known as DVCS.

    We want to investigate how sensitive our bond is to the z-spread. We can do that by computing DVCS.

    1. The way it works is that the z-spread is shocked up by 0.5 basis points and the corporate bond is priced.
    2. Then the z-spread is shocked down by 0.5 basis points and the corporate bond is priced.
    3. The difference in the price tells you how sensitive the bond is to the z-spread by 1 basis point.
    4. This measure is known as Spread’01 or DVCS.

    Spread’01 measures the credit spread sensitivity.

    The marginal change in the spread ’01 decreases when the spread is increased.

    It is very similar to DV01. Read this article to get a good understand of the DV01 Bond Risk concepts:

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