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Suspected Mistake in FRM Practice question - Credit Spread Put Option

Liming

New Member
Dear David,

I suspect that I've found another mistake in FRM practice question - question 17 from Credit Risk Sample Exam (CD of FRM handbook 5th) (appended at the end).
My basic reasoning is very simple: credit spread put option enables its buyer to profit from increase in credit spread and to hedge against price decrease; however, it doesn't mean that its seller will be able to profit from decrease in credit spread or to hedge against price increase. In fact, when credit spread narrows, the buyer will not exercise the credit spread put, therefore leaving the seller without any loss. The only thing is that the seller collects premium upfront, which I don't think is a good hedge against yield decrease since it's a fixed premium and do not vary according to the actual amount of yield change.
The optimal solution, I would say, would be for the hedger to buy a credit spread call option. So none of the 4 options is good answer.
Highly Highly Appreciate Your Opinion! (but I think if we are unfortunate enough to meet this kind of question in the 09', B would be the only option to choose because A,C,D are totally wrong)

Thank you!
Liming 18/11/09

Question 17. Your firm is holding a short position in an Argentinean bond with a notional value of ARS 5,000,000 and a coupon yield of 5.5%. Your model predicts the bond's yield will decrease over the coming year. You are asked to hedge the position. Your recommendation is to:
A Buy a credit default swap
B Sell a credit-spread put option
C Short a credit-spread forward
D Buy a total rate of return swap
Answer Provided: B
Their explanation is: to hedge against price increase as you are shorting the bond
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
HI Liming,

I totally agree with you: writing the credit-spread put is not a hedge, it is income enhancement. At best, yield drops and put is unexercised. Long CS put would hedge long bond position. But here is a short bond position, so to hedge price increase (narrowing of yield spread), the hedge is to buy a credit spread CALL.

David
 
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