Credit spread call - please explain this solution

[shrubaks123]

Bales’ research indicates that not only can credit derivates be used to protect FI’s fixed income portfolios from certain types of risks, but they can also be employed to lower the firm’s borrowing costs. Bales is able to convince FI’s CEO Tim Brown to issue the following bond:

• A 5-year, annual pay, $20 million bond offering at a rate of LIBOR plus 150 basis points.
• LIBOR is 6.5%.
• The bonds will be issued with a binary credit put, with a strike price at par.
• One year from today (t=1) (the day after the coupon payment is made) LIBOR moves to 7% and the yield on the bond is at 9.25%.

Assume that instead of a binary credit put option, FI intends to issue the bond with a credit spread call option. The bond’s risk factor is 2 and assume it is now one year from today. The value of the credit call option is closest to:

A)
the credit call is out-of-the-money.

B)
$225,000.

C)
$300,000.

• Explanation
• References

The value of the credit call is equal to the actual spread over the benchmark versus the specified spread over the benchmark times the principal times the risk factor. Note that the payoff is not binary - the payoff to the option will increase as the spread over the benchmark gets larger.
(0.0925 − 0.0700 − 0.0150) × $20,000,000 × 2 = $300,000

 

[cpk123]

Strike for the Call Option = 7% (LIBOR + 150 bps) = 8.5%
A Spread call will be in the money if the Underlying 9.25% > Strike (8.5%)
Spread value = (0.0925 - 0.085) * Face (20,000,000) * Risk Factor 2 = 150,000 * 2 = $300,000