DEFINITION of Credit Spread Option
A credit spread option is a financial derivative contract that transfers credit risk from one party to another. The credit risk in this instance is that the risk associated with the particular credit will increase causing the spread to widen, which pushes down the price of the credit. Spreads and prices move in opposite directions. An initial premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level.
BREAKING DOWN Credit Spread Option
The buyer of a credit spread option can receive cash flows if the credit spread between two specific benchmarks widens or narrows, depending upon the way the option is written. Credit spread options come in the form of both calls and puts, allowing both long and short credit positions.
Credit spread options can be issued by holders of a specific company's debt to hedge against the risk of a negative credit event. The buyer of the credit spread option (call) assumes all or a portion of the risk of default, and will pay the option seller if the spread between the company's debt and a benchmark level (such as LIBOR) grows.
Options and other derivatives based on credit spreads are vital tools for managing the risks associated with lower-rated bonds and debt.