A type of credit derivative in which the underlying is the credit spread on a bond. This spread is the bond’s yield spread relative to a benchmark.
A bondholder typically pays a premium to buy this call option to be compensated if the bond’s credit quality decreases. The bondholder chooses the strike level of the option.
When a bond’s credit quality decreases, its yield spread will increase. At expiration of the call option, if the yield spread is above the strike, the bondholder will collect a payoff based on the difference. This payoff compensates the bondholder for the drop in market price of the bond.« Back to Index