Credit risk of forward and put options: I read the notes on this, but if anybody can offer a good logic for the process of calculating the credit risk, I’ll appreciate it. Thanks for helping
Tough one… since the Euro risk-free rate’s above Canada’s, the Euro should trade at a forward discount (bad for Maple Leaf). So, you know right away that Maple Leaf’s under water and thus their counterparty has the credit risk. To calculate the amount at risk, you re-value the forward based on the interest rate differential. The difference between this and the contracted forward rate (= 1.63) is the the economic loss to Maple Leaf at expiration. To get the present value, you discount this amount using the domestic int rate. For the option, you know that only the long faces any credit risk (because they have no contractual obligation beyond the premium). Also, it’s a European option which only has potential credit risk (because it’s only exercisable at expiration). With the calculation, they try to trick you because they give direct rates which need to be converted to indirect (because Maple Leaf will convert JPY to CAD, not the other way around). The option is therefore worth the difference in the indirect strike and spot rates, times the notional principal. Unlike a forward, you don’t discount because you’re only measuring potential risk.
Thanks for the explanation- I am getting the idea- but still a little confused about what is called inflow and outflow and why, also when to use which discount rate. Response will be appreciated.
Value of Forward contract (spot - forward) Spot (/Euro) discounted by Euro IR - Forward (/Euro) discounted by IR Value of Put Option (forward - spot) Forward (/YEN) - Spot ($/YEN) Can you please explain why we are now subtracting the spot from the forward?