Forward credit spread

Forward credit spreads are based on the risky forward rate less the riskfree forward rate. The forward credit spread can be estimated as the difference between the forward yield for a benchmark bond and the yield on the reference credit asset. 

The forward credit spread can be determined by considering the spot prices for the risky security and risk-free benchmark security, while the... 

EXHIBIT 21.16 Data for the Forward Credit Spread Illustration... 

Therefore, the forward credit spread is the difference between the forward rate implied by the risky security less the forward rate implied... 

The difference between the forward credit spread and the current spread is 0.4095 - 0.40 = 0.0095% = 0.95 basis points. 

The calculation of the forward credit spread is critical to the valuation of credit spread products the payoff of spread forwards is highly sensitive to the implied forward credit spread. 

First generation pricing models for credit spread options may use models as described in the section on spread models. The key market parameters in a spread option model include the forward credit spread and the volatility of the credit spread. 

Central banks and market practitioners use interest rates prevailing in the government bond market to extract certain information, the most important of which is implied forward rates. These are an estimate of the market s expectations about the future directirMi of short-term interest rates. They are important because they signify the market s expectafirMis about the future path of interest rates however, they are also used in derivative pricing and to create synthetic bond prices from the extent of credit spreads of corporate bonds. 

The reason to use implied volatility is that market anticipates mean reversion and uses the implied volatility to gauge the volatility of individual assets relative to the market. Implied volatility represents a market option about the underlying asset and therefore is forward looking. However, the estimate of implied volatility is conditioned by the choice of other inputs in particular, the credit spread applied in the option-free bond and the conversion premium of the tmderlying asset (Example 9.2). 

Credit spread derivatives are forwards and options that reflect views on the credit spread movements of underlying credit assets. Therefore,... 

Spread forwards may be used by investors who wish to implement an investment strategy based on its view on movements in spreads. Exhibit 21.7 shows the cash flows under a credit spread forward. Exhibit 21.8 illustrates the use of a credit spread forward contract. 

An investor has the view that credit spread on the corporate issue ABC pic maturing in 2008 will narrow from today s level of 80 bps in six months. Therefore the investor enters into a 6-month credit spread forward with the counterparty (for example a bank) with strike level at the 80 bps level. The payout of the contract is structured so that as ... 

A key issue with credit spread options is ensuring that the pricing models used will calibrate to the market prices of credit risky reference assets. The recovery of forward prices of the reference asset would be a constraint to the evolution of the credit spread. More complex spread models may allow for the correlation between the level of the credit... 

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