Credit spread definition

What is a credit spread for bonds?

In the bond market, a credit spread is the difference in yield between two bonds with similar maturities but different credit ratings. Yield is the return that an investor will receive at the bond’s maturity, while a credit rating denotes the risk of default for that particular bond.

Default risk is important in bond trading, because it represents the likelihood that the bond issuer will fail to repay the value of the bond to the buyer at its maturity. Bond traders and investors can use the credit spread to compare the risk of default with the potential reward of the bond’s yield.

Credit spread formula

The credit spread formula multiplies one minus the recovery rate by the default probability. The full formula is as follows:

The recovery rate enables an investor or trader to estimate the amount of their loan that they would still receive if a bond issuer defaulted on their repayment obligations. Higher recovery rates are always preferable, because a 100% recovery rate means that a borrower will return 100% of the amount that has been lent.

Default probability is the likelihood that a borrower will not be able to meet their obligations to repay a loan over a given time period, which is usually one year. In the bond market, higher-interest bonds usually have a higher probability of default. This means issuers are forced to offer a higher interest rate or yield to entice investors to agree to the increased risk.

What is a credit spread for options?

A credit spread in options trading involves a trader taking a position on options of the same type with the same expiry and underlying asset, but with different strike prices. This is known as a vertical options spread strategy, and it can be used to achieve a credit spread or a debit spread.

A credit spread is a strategy in which the trader is receiving a premium for accepting the obligation to sell or buy at a specific price before expiry. A debit spread is a strategy in which a trader pays a premium for another market participant to take on the obligation to sell or buy their options at a specific strike price before expiry.

Strategies for credit spread options trading

Credit spreads can be either bullish or bearish, and you can use either version depending on whether you think that the underlying market will increase or decrease in value. Below, we’ve given examples of both bullish and bearish credit and debit spreads:

• A bull put spread requires the purchase of a lower strike put and the simultaneous sale of a higher strike put. This creates a net credit, which will profit if the underlying increases in value
• A bear call spread requires the sale of a low strike price call and the simultaneous purchase of a higher strike call. This will achieve a net credit, which will turn a profit if the underlying decreases in value
• A bear put spread requires the purchase of a high strike put and the simultaneous sale of a low strike put in order to achieve a net debit. This will turn a profit if the underlying decreases in value
• A bull call spread requires the purchase of a lower strike call and the simultaneous sale of a higher strike call, which will achieve a net debit and result in a profit if the underlying increases in value