Refer to 2009 CFAI exam Q9: Credit risk Part b ii) To calculate the amount at risk from a credit loss on the long JPY put option. I don’t understand why the CAD305K payoff don’t need to discount back to present value? Could someone explains?
It is POTENTIAL FUTURE risk. If you want PV --> need to know appropriate risk-based discount rate which is not given. You can’t use risk free to discount a risk, that would be an financial oxymoron :-).
Thanks!!
elcfa Wrote: ------------------------------------------------------- > It is POTENTIAL FUTURE risk. If you want PV --> > need to know appropriate risk-based discount rate > which is not given. You can’t use risk free to > discount a risk, that would be an financial > oxymoron :-). elcfa–Good point! Sometimes I got confused with current risk and potential future risk in the past; your response has led me to the right direction. Would you please confirm the following? If it is an “American option” instead of European one in this question, the company would bear the current credit risk as well as potential future risk and the VAR is equal to CAD305K discounted at a certain option-risk rate?? TYVM for your time!
James@Houston I was a bit imprecise in previous posting, so let me get more precise now. The point is that one does not do PV of potential (future) risk. One does, however, calculate current risk which is the same as market value of instrument (if it is >0). As you see, there may not be a correlation between those two values. One may have huge potential risk, but zero (negative) current risk. Concerning the option: OTC European put option It is important to note that it is an OTC option, so it is assumed to have NO market value thus no current risk since it is not (assumed to be) tradable. OTC American put option --> can exercise now and get 305KCAD --> current risk = market value of the option = 305kCAD. Now, if it had been an exchange traded option, Exchange-traded European put option: current risk = market value of the put as traded in the market (as determined by Black Scholes). Exchange-traded American put option: current risk = market value of the put as traded in the market. The current risk in this case will no doubt be higher than 305KCAD as well as higher than the value of the Exchange-traded European put option. In all four cases, the potential (FUTURE) credit risk is 305KCAD. Hope it answers your question.
Sorry, I get some confusion. Refer to 2010 Schwester note. Book 4. P.90. example 1. Why do they discount the “potential (future) risk” ($9433.96) on future contract at risk free rate (4%)?
Well. The text is, I believe, a bit clumsy worded, if not correctly wrong and thus misleading. It was trying to determine the market value of the FRA, not the “PV of the associated credit risk is the FRA payoff discounted for the three months at the risk free rate…” As I mentioned, market value of instrument is the credit risk which in THIS PARTICULAR case happens to be the PV of potential credit risk, but not in most cases as I have demonstrated above. Schweser words would lead one to generalize the case which causes misunderstanding, I believe. Hope that it is clearer.
Thanks. Just to confirm… Current credit risk of FRA = MV of FRA (= $9341.91) Potential (future) credit risk = payoff of FRA (=$9433.96) Is that correct?
B_C Wrote: ------------------------------------------------------- > Thanks. Just to confirm… > > Current credit risk of FRA = MV of FRA (= > $9341.91) > Potential (future) credit risk = payoff of FRA > (=$9433.96) > > Is that correct? yep
Appreciate for your help!!
Sorry, here comes another question confused me. Refer to Schweser practice exam Vol1. Exam 2. Afternoon Session. Q14.3. A forward contract sold by XXX has 6 month until the delivery date and a contract price of 50. The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract no funds were exchanged upfront. Determine whether the forward contract have current and/or potential credit risk. The book answer say it has no current credit risk as no amount is due now but has potential credit risk of $50-PV($50). Why the potential (future) credit risk is not the FV payoff, which is = $50-$50 = 0?
Now it is my turn to be confused. I went back to reread the CFAI text. Per definition, Current credit risk: amounts due at present time not be paid, i.e., any payment due (from counterparty), not market value. Potential credit risk: Market value at a given time reflect potential credit risk, i.e., the value of the contract if the counterparty defaults now. The CFAI text uses the “credit risk” term quite liberally to mean both current AND potential, thus creating confusion. It seems to mean that credit risk = MAX (current credit risk, potential credit risk). To make confusion complete, it uses new terms like “amount at risk from a credit loss (exam 2009)” which I take to mean credit risk, which again assumed to be MAX (current credit risk, potential credit risk). so let me review and correct my previous posting, based on what I make out of this mess. elcfa Wrote: >current risk which is the same as market value of > instrument (if it is >0). wrong: potential risk (NOT current risk) is the same as market value of the instrument As you see, there may > not be a correlation between those two values. One > may have huge potential risk, but zero (negative) > current risk. Still correct. > Concerning the option: > > OTC European put option > It is important to note that it is an OTC option, > so it is assumed to have NO market value thus no > current risk since it is not (assumed to be) > tradable. No money due now so current risk =0. Market value, due to being OTC, indeterminable thus potential risk unknown. One can either use Black and Scholes or discounting future payoff with a risk-based discount. > OTC American put option --> can exercise now and > get 305KCAD --> current risk = market value of the > option = 305kCAD. > Current risk COULD BE 305KCAD. the CFAI is not 100% clear about current risk being equal 305KCAD in this case. It says “current credit risk COULD arise if the option holder decides to exercise”. Potential risk = at least 305KCAD. At least, since the market value is still indeterminable. > Now, if it had been an exchange traded option, > Exchange-traded European put option: current risk > = market value of the put as traded in the market > (as determined by Black Scholes). > current risk = 0 since no money due. potential risk = Market value as traded. > Exchange-traded American put option: current risk > = market value of the put as traded in the market. > The current risk in this case will no doubt be > higher than 305KCAD as well as higher than the > value of the Exchange-traded European put option. > potential risk= market value of option > 305KCAD. current risk COULD BE = potential risk. See note about OTC American put option above. > In all four cases, the potential (FUTURE) credit > risk is 305KCAD. correct, but one should probably not use a new term: potential FUTURE credit, just potential credit and its value is stated above. B_C for your example. >The book answer say it has no current credit risk as no amount is due now but has >potential credit risk of $50-PV($50) current credit risk =0 potential credit risk = market value = $50-PV($50) >Current credit risk of FRA = MV of FRA (= $9341.91) >Potential (future) credit risk = payoff of FRA (=$9433.96) Current credit risk = 0 since no money due. Potential credit risk = $9341.91. Hope that the confusion is now complete :-).
B_C Wrote: ------------------------------------------------------- > Sorry, I get some confusion. > > Refer to 2010 Schwester note. Book 4. P.90. > example 1. > > Why do they discount the “potential (future) risk” > ($9433.96) on future contract at risk free rate > (4%)? Do you think it is correct to discount the “potential (future) risk” ($9433.96) on future contract at risk free rate (4%) ? This seems discrepant from what we learned in level 2. I think it shall be discount at the Libor rate of 90 days (t=90 ~180) at t = 90 days. Anyone can clarify ?
Hm. Good point. I would say yes, though I have not thought too hard about it. We are talking about PV of the FRA and one should use LIBOR for this. The swap of example 8 CFAI text also uses LIBOR to discount to get to PV.