In this workout, we look at a company, Company B, where we expect the credit worthiness of the company to weaken. How can we trade on the back of that? Assuming no change in the treasury yield curve and a $5 million short position, what will be the resulting profit or loss if the below scenario comes true? The risk-free rate is 1.75%. The current spread for this bond, Company B, is 3% but we expect the spread over treasuries to expand to 4.2%. A big expansion there in the spread.

The bond terms are simple. The remaining time to maturity is five years. The annual coupon is five, and the par value is 100. So what do we expect the price of the bond right now to be? Well, we're gonna use the PB function and the risk free rate is 1.75 and the current spread is three. So together they make up the yield to maturity, at the moment.

The number of years is still five, the annual coupon is five, and the power value is 100. So at the moment, we expect the price of the bond now to be 101.1. So what if the spread expands to 4.2%? What do we expect the price to do then? Well, let's calculate it.

We're gonna use the PV function and we're gonna first figure out what the new yield maturity is. Well, it's going to be the risk-free rate, plus the new spread, the 4.2% spread there. The rest is the same. The number of periods is five, the coupon is five and the power value is 100. Right, so if we're correct we expect the bond price to go from 101.1 to 96. So we decide to short this bond. What does that really mean? Well, effectively it means that we borrow bonds to the value of 5 million and then we immediately sell them. So that means of course, we're short these bonds that means we have to pay away at some future time the value of these bonds. So as we do this, we raise $5 million.

But what is the short position worth after the spread has changed? Well, off course, that's gonna be much lower now. So it'd be the new price divided by the old price times the initial position. So all of a sudden, our short position is worth much less, $4.7 million. So that means we owe less, so we have a profit here of the difference, $252,000 approximately. And the percentage profit there of course, will be the 252, the profit divided by the original investments here, 5.4%. So we made 5.4% on successfully shorting this bond.