Credit derivatives: Risk factor

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Quick question on the “risk factor” in the spread related credit derivatives:
Credit spread options and credit forwards have a “risk factor” that is multiplied to obtain the payoff, eg. credit forwards (payoff to buyer) = (spread.at.maturity - contract.spread) * notional * risk.factor
What is this risk factor? Thanks, OA
 
old_akakaraka Wrote:
——————————————————-
> Quick question on the “risk factor” in the spread
> related credit derivatives:
>
> Credit spread options and credit forwards have a
> “risk factor” that is multiplied to obtain the
> payoff, eg. credit forwards (payoff to buyer) =
> (spread.at.maturity - contract.spread) * notional
> * risk.factor
>
> What is this risk factor? Thanks, OA
My take on it is this. I’ve never heard of it before. I’m just assuming it’s similar to the Futures Multiplier. I don’t think there’s any point in knowing what it stands for or means, but just know how to use it.
Feel free to disagree, but that’s how I’m playing this one, lol.
 
Thanks - but I guess this is different: futures mutliplier is just the number of futures you have to buy at once, i.e. you can not buy a single future on S&P but would have to buy, say, 250. (If i understood this correctly) So for a S&P of 900$, mutliplier 250, a contract would cost 250 * 900 (is this right?)
However, the risk factor seems to be different, and not necessarily integer. I dont get what it is.
 
I guess the risk factor is related to the duration of portfolio you want to hedge.
- If the portfolio has a large duration, you would buy credit derviative
that has a large risk factor.
- The nominal value of the credit derivative equals the value of your portfolio.
By do so, the change in value of your portfolio will be offset by the change
in value of the credit derivative
 
I understand it as equivalent to ‘leverage’. You want to play on the same factors, and suppose regulations say that you can play the game on the Notional ( which might be the underlying exposure) , a is prevelent in India.
But you want to take more risk. One way is increase the notional ( not allowed due to some reason) , other way is to play on the risk factor.
 
Risk Factor = the change in the value of a the underlying bond for a 1bp change in the credit spread. Although similar to Duration, you’re measuring the price change of the underlying to a change in CREDIT SPREAD, not interest rate.
Hope this helps
 
Bankerboy makes a lot of sense
since the derivative protects you against change in spread, the change in spread changes the price of the bond depending on the risk factor.
 
Bankerboy Wrote:
——————————————————-
> Risk Factor = the change in the value of a the
> underlying bond for a 1bp change in the credit
> spread. Although similar to Duration, you’re
> measuring the price change of the underlying to a
> change in CREDIT SPREAD, not interest rate.
> Hope this helps
But schweser vol 3 Pg 197 says, ” the size of notional principal and risk factor are calibrated to the level of protection desired by the portfolio manager”
Doesn’t this imply that risk factor is extrinsic to the underlying bond rather than being a property of it?
 
I can’t comment on Schweser’s notes as I’m reading CFAI books. The definition i gave comes straight from the text. To answer your question though, credit spreads are a natural component of non-sovereign bonds. So, it will certainly be intrinsic to the value of the underlying bond. Risk factors, in my opinion, are not generally used in bond pricing methodology - so you appear correct in your last comment. It seems that RF’s are merely a factor used for deterninig credit spread options and forwards.
But I wouldn’t get bogged down on this. Focus, instead, on applying the formula - there’s too much material to review in the next 3.5 weeks to get concerned about a non-LOS issue.
 
bhaiyyu I think what they mean is that you can choose to protect the whole exposure or just a portion of it depending on the manager’s choice
but the portion that you do protect, needs to take into account the change in spread*the impact that this change in spread would have on the bond price(=risk factor)
 
Probably just remember to include risk factor adj for credit forward and credit spread option (not binary credit option which is just OV = max{(strike - value),0]) will do.
 
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