2009 CFAI exam Q9: Credit risk

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!

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