TABLE OF CONTENTS The credit derivatives instruments we have examined thus far have in common the fact that their final payoffs are essentially tied to default events involving the reference entity. Spread and bond options deviate from this norm. Spread option payoffs are generally specified in terms of the performance of a reference asset relative to that of another asset. Bond options are options to buy or sell bonds at a future date at a predetermined price. Both types of options can be exercised regardless of whether or not the issuers of the underlying assets have defaulted. They are credit derivatives because they involve the yield spread of a credit risky asset over that of some benchmark asset the spread option or the market price of a risky bond the bond option. As we shall see below, the basic structure of spread and bond options is similar to that of standard call and put options.
To understand the workings of a credit option it is best to start with a simple example. Suppose you want to have the option, but not the obligation, to buy a particular five-year asset swap one year from today. [1] You want the asset swap to reference a fixed-rate bond issued by XYZ Corp. and to have a prespecified par spread of ?. You approach an options dealer and agree to pay her an amount X today so that she will be ready to sell you that asset swap in one...
