Question

You are a salestrader on the high-yield bond desk. A client that you have covered for many years has recently moved from a mutual fund to a small startup hedge fund. For the first time in his career he is allowed to take short positions in addition to long positions. He believes the market is underpricing the risk of defaults in the auto parts sector. He asks you to explain his options for expressing this view. Can you explain the two main types of trades he could establish that are related to chemical sector bonds, including the mechanics and pros/cons of each?

Answer 1

1) He can buy put option or sell call option. Buying involves initial outlay in form of premium. Here risk is limited to premium paid but profit is unlimited. Put option gives it's holder right to sell underlying asset at specified price at expiry. Seeling call involves receiving premium. here profit is limited to premium but loss is unlimited.

2) Another option is he can short future contract. Future contract obliged parties to buy sell an asset at particular price in future. It is daily mark to market.