From page 219 of the Schweser Note (Bk.2), it says that "Out-of money put options have more WWR than in-the-money put option. I get confused and should it be the in-the-money put option has more WWR because of the following:
the risk exposure is greater to the counterparty since it has to pay the option buyer; and
the probability of default of the counterparty is greater as the share price of the counterparty drops (assuming the counterparty is also the issuer of the security)
It simply means that if the long buys the-out-of-the-money put option initially and suppose at the end of the period, this option has the value (X>S). This implies that the value of the underlying asset has dropped significantly. Since the note assumes that the counterparty (short)) and underlying issuer are the same (refer to page 220 on professor note), the issuer would suffer the huge loss from the fall of iunderlying asset value and might not be able to pay the amount it owed to the long.
How come the issuer face wrong way risk??? The WWR is solely to the holder of the option (i.e. long to the put option). An out of the onty put option would mean S>X, hence the price of the option is an should be less eery other thing remaining constant.
Now if it is in the money then X>S and this is where the chances of WWR increases as the underlying decreases in value and at the same time may create downward pressure on the issuer (assuming the issuer of the option is also the issuer of equity) ability to honour the commitment.
Ok, I will try to explain again. At the start, the long purchases the out-of-the-money put option (a very low relatively X) by paying little premium to the short (assuming that the short is the issuer of the underlying so the short is holding the asset) “I know the short is not using the option to hedge”
Suppose at the end of the period, the price of underlying (S) drops substantially that the S is lower than the very low X (X>S). The short is likely to suffer from the huge loss for holding the underlying assets and might not be able to pay the value gained in the long put position. So, this is the example of WWR.
To understand more easily, just assume that the put option is out-of-the money at the start of period not at the end of the period.
Ok Juz… it makes sense somewhat. But there is a strong assumption underlying nonetheless… that the put option is nowmoving in the money from out of the money i.e. so say that from the begining period out of the money should the put option move in the money the WWR increases and this increase in WWR would be MORE than the option which either has been issued at the money or a little out of the money or say moves into the money quite early in the option’s life. But it is nonetheless very hard to imagine.