credit options

A type of credit derivative instrument. Options on a credit spread take the form of credit-spread put options. The put-buyer pays an upfront fee to the put-seller in exchange for a contingent payment in the event that the credit spread for an asset rises beyond a pre-agreed upon threshold. This is a put option where the underlying is the spread on a third party security. For example, if you were holding a bond issued by a third party and the bond's spread over the comparable Treasury rate were 200 basis points, you might purchase an option that pays off if the spread widens to 300 basis points. (Although that example uses the Treasury rate as a basis for comparison, it is becoming more common to use swap rates.) In other words, the widening of the credit spread to a defined size gives the protection buyer the right to demand a payment from the protection seller. Unlike a total return or default swap, the parties in a credit spread option do not have to agree upon any specific credit events. The fact that the market spread for the underlying rises compared to the reference index rate is, in effect, a proxy for a deterioration in the credit quality.

Also known as credit spread options and credit spread put options. American Banker Glossary