It says he purchased a call option for $30, and the current value of the option is $35, and the answer says he is exposed to $35 in credit risk… I don’t really understand this, I thought the purchase of a call option is considered a sunk cost, and then you are only exposed to credit risk if the Spot price is higher than the strike price. Can someone explain this.
Yea, I thought this was also a stupid question because although the counterparty must sell the underlying to you at 30 and the current price is now 35 so they’re only at a $5 loss. I don’t understand how your credit risk is greater than your counterparty’s potential loss.
I thought so too However upon reading the CFAI answers… If you are a holder of a call option with strike of $30 and stock price is now $35, then technically you can become holder of a stock worth $35 if you exercise the call. If the counterparty defaults, then you can not exercise the call and can not receive the stock, so you lose out on the $35. Get it?
Now that I think about it though it does make some sense. If your counterparty defaults and does not fulfill their obligation to sell to you at 30, you will have to buy it in the market at 35. That’s your credit risk in this question, what it would cost you if your counterparty defaults, which is $35.
credit risk is current payoff : $35. It does not matter that $30 was paid earlier to purchase the option, since that is already paid and sunk (as you mentioned). What matters is that if the counterparty were to default now, it would take all your $35 with it - and thats what the credit risk is.
if the counterparty were to default now, it would take nothing from you. but, if you still wanted to have the same position that you would have had if the counterparty had NOT defaulted, it would cost you $35.