Could someone please simplify to me who is exposed to counterparty risk (buyer/seller) on interest rate derivatives (caps/floors)? Q#3, Reading 62 A: “Once a fee for the interest rate floor is paid, the seller of an interest rate floor is not exposed to counterparty risk. Only the seller, not the buyer, must perform.” My brain is so fried right now Thanks
right the buyer is exposed if the seller doesnt pay when the IR drops below the floor rate
The seller received the premium (aka his maximum gain on the transaction), so the buyer has no obligation to the seller.
Buyer is buying the interest rate floor from the seller. 1) Seller sells the floor to the buyer for a premium 2) Interest falls lower than the floor, Buyer says to Seller, “hey you owe me the difference, cough it up.” 3) Seller goes “wuh? You crazy, Do I know you?” Buyer: "Dude, interest rate lower than the floor I bought from you, pay up " Seller: “Ohh~~ that’s riigghht. Okok, let me go home and get it… Wait here kk?”
Perfect! Thanks for your help guys, and I’m hoping to see a vignette similar to joeshph213’s on the exam.