Which Credit Derivative is the best?

CFA Level III Fixed Income
#1

If we want to hedge against a possible downgrade in ratings, which credit derivative is the best and why?

  1. Credit Forward

  2. Binary Credit Option

  3. Credit Spread Option

#2
  1. Binary credit option, because there are 2 scenarios, the rating will either be downgraded or not
#3

Right. So, Credit Forward can’t be the answer. But what about Credit Spread Option? It also has assymentric payoffs.

#4

Credit spread option does not fully correlate to ratings changes. Sure, the spread could widen after a credit downgrade, but the binary option is the BEST option because it specifically protects against rating changes

#5

A credit spread option will only pay off on a net widening.

What happens if global credit tightens 25bps, while the issuer’s credit widens 25bps? Then the net impact is 0bps, the option has no payoff, but you are still 25bps worse-off from a rv perspective bcuz you missed the tightening.

Short answer: credit spreads may change due to other stuff, so its an imperfect hedge.