How are credit options priced, and what is the difference between a credit spread option and a credit default option?

Question

AcadiFi · Accepted Answer

Credit options are an important component of the CFA Level II credit derivatives curriculum. The two main types serve very different purposes.

## Credit Spread Option

A **credit spread call** profits when the credit spread **widens** beyond the strike spread. The underlying is the yield spread itself.

**Payoff** = max(Spread_T - K_spread, 0) x Duration x Notional

The duration multiplier converts a spread change (in basis points) into a dollar price change.

## Credit Default Option (Binary Credit Option)

A **credit default option** pays a fixed amount if a **credit event** (default, bankruptcy, restructuring) occurs. It is essentially a digital option on a credit event.

**Payoff** = Fixed Amount (if credit event occurs) or $0 (if no event)

## Comparison

| Feature | Credit Spread Option | Credit Default Option |
|---|---|---|
| Trigger | Spread exceeds strike | Credit event occurs |
| Payoff type | Variable (proportional to spread) | Fixed (binary) |
| Risk covered | Mark-to-market loss from widening | Actual default loss |
| Pricing approach | Modified BSM on spreads | Default probability model |

## Worked Example — Pemberton Credit Portfolio

Pemberton holds $20M notional of Graystone Industries bonds with a modified duration of 5.2 years. Current spread: 180bps.

**Scenario 1: Credit Spread Call (strike = 200bps)**
Pemberton buys protection. If spreads widen to 280bps:

Payoff = (280 - 200) x 0.0001 x 5.2 x $20M = 80 x 0.0001 x 5.2 x 20M = **$832,000**

**Scenario 2: Credit Default Option (payout = $2M)**
If Graystone defaults, Pemberton receives $2M regardless of recovery rate. If no default, Pemberton receives $0.

## Pricing Considerations

Credit spread options can be priced using a modified Black model where:
- The underlying is the forward credit spread
- Volatility is the spread volatility
- The model assumes lognormal spread distribution

Credit default options are priced using:
- The risk-neutral default probability (extracted from CDS spreads)
- Recovery rate assumptions
- Discounting at the risk-free rate

**CDS Connection:** A credit default swap can be viewed as a strip of credit default options — each premium period represents a conditional payment contingent on no prior default.

**Exam tip:** CFA Level II focuses on the conceptual distinction between these instruments. Know that spread options protect against mark-to-market losses while default options protect against actual credit events.

For more credit derivatives content, explore our CFA Level II course.

How are credit options priced, and what is the difference between a credit spread option and a credit default option?

Master Level II with our CFA Course

Related Questions

Practice Questions