Question asks for which action to take (Buy Long or Sell Short) and expected payoff under the following two strategies. When you enter the contract the credit spread of your corporate bonds is 100bps and you have concerns spreads will widen. At expiration spreads are 150bps.
i) Forward Contract
My Answer: I thought if you had concerns spreads will widen then you would want to off load credit risk by selling short forward contracts, because if Credit spreads are worsening then when you sell short your are protecting from downside price risk, therefore payoff is positive.
ii) Call option Contract
My Answer: If spreads widen, then bond price goes down. Therefore sell Call options and collect premium for positive pay off.
After reading the correct answer and CFAI explanation I am really confused as why i am completely wrong and where the break down of my logic is. Can someone please advise?
They are forwards and options on credit spreads though. Not on bonds. That is what you have to look at it.
Sorry I still don’t get it. What is the difference? Isn’t there an inverse relationship on credit spreads. For example, when Credit spread increases then price decreases?
So I’m unfamiliar with the whole question, but nowhere do you state that you are long the underlying (corporate bond). Thus, you aren’t really looking to hedge, but you’re looking to exploit the market. Actually, this info isn’t that relevant. So moving on…
In this case they’re asking about rates (not bond prices). Longing Bond Call options is the same thing as saying you are short rates (thus expecting an increase in bond prices and decrease in rates). Here we have increasing rate expectation, so long rates (buy calls) and short bond calls. Credit spread forwards only pay off if rates increase…
Long position; investor expects credit to worsen and spread widen, so payoff will be (Spread at maturity minus Strike spread) x Notional Amount x Risk factor.
Short position; investor expects credit to improve and spread narrow, so payoff will be (Strike spread minus Spread at maturity) x Notional Amount x Risk factor.