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Credit Spread Forward


A credit spread derivative whose payoff is based on changes in the perceived credit quality of a reference credit as reflected in the credit spreads. More specifically, a credit spread forward is a cash-settled forward contract in which settlement amounts are based on the credit spread between two prespecified debt issues on the maturity date. In other words, the underlying asset in this forward contract is a credit spread. The payoff of a credit spread forward can be calculated using the following formula:

Credit Spread Forward

where N is the notional amount, K is the credit spread today, S(t1) is the actual spread at time (t1). Both credit spreads are expressed as percentages. The duration is given by:

Duration

Where duration is expressed as the weighted average of the times on which payments are made (the weights add up to one).

Purchasing a credit spread forward means entering into a long position in the underlying bond (the buyer expects the risky bond price will increase relative to the risk-free bond. If that turns out to be true, the buyer receives the payoff from the seller.



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Derivatives have increasingly become very important tools in finance over the last three decades. Many different types of derivatives are now traded actively on ...
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