Credit spread option

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.

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