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In recent years, a new type of derivatives has come on the scene to hedge credit risk. Like other derivatives, credit derivatives offer payoffs on previously issued securities, but ones that bear credit risk. In the past ten years, the markets in credit derivatives have grown at an astounding pace and the notional amounts of these derivatives now number in the trillions of dollars. These credit derivatives take several forms.

Credit Options

Credit options work just like the options discussed earlier in the chapter: For a fee, the purchaser gains the right to receive profits that are tied either to the price of an underlying security or to an interest rate. Suppose you buy $1 million of General Motors bonds but worry that a potential slowdown in the sale of SUVs might lead a credit-rating agency to downgrade (lower the credit rating on) GM bonds. As we saw in Chapter 5, such a downgrade would cause the price of GM bonds to fall. To protect yourself, you could buy an option for, say, $15,000, to sell the $1 million of bonds at a strike price that is the same as the current price. With this strategy, you would not suffer any losses if the value of the GM bonds declined because you could exercise the option and sell them at the price you paid for them. In addition, you would be able to reap any gains that occurred if GM bonds rose in value.

The second type of credit option ties profits to changes in an interest rate such as a credit spread (the interest rate on the average bond with a particular credit rating minus the interest rate on default-free bonds such as those issued by the U.S. Treasury). Suppose that your company, which has a Baa credit rating, plans to issue $10 million of one-year bonds in three months and expects to have a credit spread of 1 percentage point (i.e., it will pay an interest rate that is 1 percentage point higher than the one-year Treasury rate). You are concerned that the market might start to think that Baa companies in general will become riskier in the coming months. If this were to happen by the time you are ready to issue your bonds in three months, you would have to pay a higher interest rate than the 1 percentage point in excess of the Treasury rate and your cost of issuing the bonds would increase. To protect yourself against these higher costs, you could buy for, say, $20,000 a credit option on $10 million of Baa bonds that would pay you the difference between the average Baa credit spread in the market minus the 1 percentage point credit spread on $10 million. If the credit spread jumps to 2 percentage points, you would receive $100,000 from the option (= [2% — 1%] X $10 million), which would exactly offset the $100,000 higher interest costs from the 1 percentage point higher interest rate you would have to pay on your $10 million of bonds.

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