Credit risk per the CFA: “The risk of loss caused by a counterparty’s … failure to make a timely payment…”
Let me imagine this out loud and PLEASE tell me what I’m missing!:
- I’m a dealer - who has written a call option for a counterparty wanting to purchase said call option.
- It’s an OTC call option, European, for 1,000,000 shares of Amazon (with a strike at, say, 1000).
- At expiration, the call is in the money and lo and behold the counterparty calls me up and says “deliver to me the 1,000,000 shares of Amazon at our agreed upon price!”
- [I’ll sell it to her, but ONLY if she’s got the BILLION dollars to pay for it.]
- If I have my custodian transfer the million shares and she doesn’t deliver the BILLION bucks, I feel like I’ve just experienced credit risk.
- I kick myself in the forehead - using my leg with its hyper-flexible knee joint.
Isn’t that “credit risk”?
The CFA says that in the answer key to the 2015 AM exam, question 6 part C, that: “Further, credit risk with options is unilateral, meaning that the option buyer faces all the credit risk and the seller none.”
Oh and they say that elsewhere… but, regardless - isn’t my scenario indicative of a option writer having credit risk?
If your custodian transfer shares and not deliver money you would be able to cancel or recall transaction since is electronic transaction and those shares are immaterial electronic record. However, this situation is quite impossible to happen and cannot be classified as a credit risk than risk of failure of total financial system or what else. You might be hacked while transaction is in progress via man-in-the middle attack too, but such situation is not counterparty (credit) risk.
Flashback - I appreciate your honesty and that sense of humor. I agree in principle with your angle, but I’m frustrated with the CFA not indicating that the credit risk is mitigated by the assumed responsibilities of custodians.
As I type that, I realize a failing in my logic; if I am frustrated with the assumption that the custodian will make everything kosher and do things like reverse the transaction, then I should not accept the fact that contracts traded on an exchange are without credit risk due to the exchange … which is guarantying fulfillment in the case of futures (as contrasted with forwards).
Enough time wasted on this - gotta go refresh my ethics.
You don’t have credit risk.
You aren’t obligated to perform.
Unless the money’s delivered.
No credit risk.