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A narrowing of yield spreads (between bonds of different risk ratings) implies that the market is factoring in less risk, probably due to an improving economic outlook. The TED spread is one commonly-quoted credit spread. The difference between Baa-rated ten-year corporate bonds and ten-year Treasuries is another commonly-quoted credit spread. [2]
The high and low of this index has varied widely. During times of financial stress, such as the Lehman Brothers or Fannie Mae and Freddie Mac bankruptcies of 2008, the Greek credit crisis of 2010, or the U.S. credit rating downgrade of 2011, the value on the index spiked. [9] It would then subsequently fall as concerns eased. [10] [11]
Credit spreads are negative vega since, if the price of the underlying doesn't change, the trader will tend to make money as volatility goes down. Credit spreads are also positive theta in that, broadly speaking if the price of the underlying doesn't move past the short strike , the trader will tend to make money just by the passage of time.
For an MBS, the word "option" in option-adjusted spread relates primarily to the right of property owners, whose mortgages back the security, to prepay the mortgage amount. Since mortgage borrowers will tend to exercise this right when it is favourable for them and unfavourable for the bond-holder, buying an MBS implicitly involves selling an ...
The credit spreads for 5 yr. bonds started 1998 around 40 basis points in Britain and near 15 basis points in Germany. As news of problems in the Hedge Fund industry and potential credit unwinds began to permeate the market, the British spread exploded out to 140 basis points in October of '98 while the German spread managed only a meager move ...
The lower the credit rating, the higher the spread, thus reflecting the extra yield premium demanded for greater risk. Using this model we can describe returns of, say, an A-rated security in terms of movements in the AAA curve, plus movements (tightening or widening) in the credit spread.
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