Part (B), Q17, p.75, CFAI vol.5 Tony believes the price of an underlying, currently selling at $96, will increase … so he purchases a European call option expiring in 6 month … The call option has an exercise price of $101 and sells for $6. (B) How much is the current value of the potential credit risk, if any? Ans: $6. Why is that so? - sticky
My guess - the current credit risk is the money you just gave away - 6$. That would also be the potential risk for now. Once the stock goes above 107, the current credit risk would be - Current Stock Price - 101. Ofcourse, it’s easier to speculate once you have seen the answer 
Just say that credit risk is the risk you take on if the person declares bankruptcy and you get nothing. You bought for $6, counterparty dies or (worse) declares bankruptcy, and you’re out $6.
JoeyDVivre Wrote: ------------------------------------------------------- > Just say that credit risk is the risk you take on > if the person declares bankruptcy and you get > nothing. You bought for $6, counterparty dies or > (worse) declares bankruptcy, and you’re out $6. But the option is out-the-money, so technically if he dies, you didn’t lose anything anyway.
But if the person dies, they can’t fufil their end of the contract (i.e. if you excercise the option in 6 months) so you’re out $6 and you get nothing in return if the option is in the money in 6 months. AND the option is currently worth $6. if the person dies, you can’t turn around and sell that option to someone else for $6 (in theory, but i’m sure some would try and transfer the credit risk).
mo34 Wrote: ------------------------------------------------------- > JoeyDVivre Wrote: > -------------------------------------------------- > ----- > > Just say that credit risk is the risk you take > on > > if the person declares bankruptcy and you get > > nothing. You bought for $6, counterparty dies > or > > (worse) declares bankruptcy, and you’re out $6. > > > But the option is out-the-money, so technically if > he dies, you didn’t lose anything anyway. All those out of the money options that you own that are worth nothing, I would like you to send them to me. Thanks.
strikershank Wrote: ------------------------------------------------------- > But if the person dies, they can’t fufil their end > of the contract (i.e. if you excercise the option > in 6 months) so you’re out $6 and you get nothing > in return if the option is in the money in 6 > months. > > AND the option is currently worth $6. if the > person dies, you can’t turn around and sell that > option to someone else for $6 (in theory, but i’m > sure some would try and transfer the credit risk). The time value of the option is $6, how does that translate to your potential credit risk?
JoeyDVivre Wrote: ------------------------------------------------------- > Just say that credit risk is the risk you take on > if the person declares bankruptcy and you get > nothing. You bought for $6, counterparty dies or > (worse) declares bankruptcy, and you’re out $6. But the $6 has been paid on the purchase of the option and there should not be any credit risk, right? Oh the answer says — “The current value of the potential credit risk is the current market value of the option, which is $6. Of course, at expiration, the option is likely to be worth a different amount and could even expire out of the money.” Just thinking if this could be another errata … - sticky
mo34 Wrote: ------------------------------------------------------- > JoeyDVivre Wrote: > -------------------------------------------------- > ----- > > Just say that credit risk is the risk you take > on > > if the person declares bankruptcy and you get > > nothing. You bought for $6, counterparty dies > or > > (worse) declares bankruptcy, and you’re out $6. > > > But the option is out-the-money, so technically if > he dies, you didn’t lose anything anyway. exactly! So why the $6? - sticky
its very simple you are purchasing something that is WORTH $6 and there is a risk of not receiving the benefit of WHAT YOU PAID for exercise price, spot price, index price, future price, tony’s suit’s price… all irrelevant
turkish_dude Wrote: ------------------------------------------------------- > its very simple > > you are purchasing something that is WORTH $6 > > and there is a risk of not receiving the benefit > of WHAT YOU PAID for > > exercise price, spot price, index price, future > price, tony’s suit’s price… all irrelevant Actually following this logic the potential credit risk is infinite. There is no current credit risk for European options (can’t exercise them before expiration).
Mo34. Think about an option for a second and how it is valued. It doesn’t have to be exercised to have value. It doesn’t have to be an american option to have value. The black-sholes model values the option at a point in time given the value of the underlying, the strike price, estimated volatility of hte underlying, risk free rate. So at a point in time you can pinpoint (at least the market pinpoints) the value of an option and the options current credit risk - which for call options, assuming you are long, can be infinate (you are correct there) but finite for put options. The exercise date doesn’t matter as european options have a value and associated credit risk at any time up to and including the expiry date. Now, if you are long an option you paid $6 for, you take on the risk of not getting what you paid for. That doesn’t mean you have to exercise the option to get what you paid for, but you could lose the OPTION of exercising prior to expiration which cost you $6.
guys, are we not going too far away? you already paid $6 to buy a call which is out-of-money at the moment. What is the potential credit risk to you? 1. I don’t understand why your potential credit risk is the paid $6. 2. If the call is now in the money by $1, what is your potential credit risk? And please read the CFAI questions and answer for details. - sticky
the call is out-of-money means the intrinsic value is 0. However, the option cost may not be 0. In this case it’s 6 and that results in credit risk.
Why is this difficult? Suppose you pay someone $6 for a truckload of dirt. Before they deiver it you have $6 worth of credit risk because if they go under, you don’t get your dirt. When you pay $6 for an option you are paying for intrinsic and time value. He goes under and takes away the time value and you have lost your $6.
sticky Wrote: ------------------------------------------------------- > guys, are we not going too far away? > > you already paid $6 to buy a call which is > out-of-money at the moment. What is the potential > credit risk to you? > > 1. I don’t understand why your potential credit > risk is the paid $6. the payment of $6 gives someone a right to participate a transaction. even the transaction may be worth millions but the person is not exposed to any default risk of millions. the risk for holder of the option faces is to lose his/her right to participate the transaction when time is due. the value of this right is worth $6 in this case can this risk be more than $6? no, because that’s how much this right worth at the time of purchase. can this risk be less than $6? well, people may argue that the option might have priced in the default risk of counterparty. i really doubt it. an call option on s&p reflects various expectations on s&p. but i dont think it reflects if my counterparty is bear or goldman. so, since this risk is not priced in, then the value of potential counterparty risk can only amount to the money on-the-line between the two parties which is $6 in this case.
CFAI text - volume 5 page 48/49 “If the short declares bankruptcy before expiration, the long has a claim on the value of hte option under bankruptcy law”
Makes sense, thank you … It has nothing to do with in or out the money, it’s just an accounting issue.
ALSO - be careful of the wording. This thread talks about POTENTIAL credit risk (and we answerd that correctly). CURRENT credit risk is $0 for european options.
If the counterparty declares bankruptcy, then the option is guaranteed never to be paid and therefore becomes worthless whether it is in the money or not, and regardless of what traditional option pricing formulae say its value should be. If your counterparty had a credit event, then no one will buy your option if you decide to get rid of it, because everyone would know that it won’t be paid. If yourcounterparty has good credit, then you can get $6 for your option’s time value if you sell it. Because the counterparty’s bankruptcy affects your ability to collect in the future and to sell the option before then, it is a credit risk. It would seem to be a current risk to me, because it affects my ability to resell the option today, but the CFA material says it is potential credit risk so that is how I will answer on the exam.