Financial Education

There are three primary types of credit risk:

• Default risk is the chance the issuer will fail to meet its obligations
• Credit spread risk is the chance the spread between the risky bond and risk-free securities will vary after purchase
• Downgrade risk is the chance a rating agency will lower its rating on the issuer

These risks can be hedged using option contracts.

A binary credit option pays off only if a specified negative event occurs. These can be used to hedge default risk or downgrade risk.

Credit spread options pay off based on the spread over a benchmark rate. They can be used to hedge credit spread risk.

For more information, see all articles on: Derivatives, Fixed income investments, Futures, Investing in bonds, Portfolio Management

See also:

Identifying Financial Risk Exposures

Managing Credit Risk Associated With Derivative Contracts

Alternative Routes to Hedge Fund Return Replication

The Role of Derivatives in Rebalancing

Hedge Fund Strategies: Risk Arbitrage