Greg buys a Call option on an asset which is currently selling at $100. The strike price of this European option is $105 and the option sells for $7. What is the current value of potential credit risk? a) None b) $5 c) $7

A - None if it is traded on an exchange

B. If it’s OTC

C

C. That’s the amount the long could claim if the short went bankrupt before expiration.

A - option is out of the money

It is clearly C. That’s the value of the option just paid to the seller, isn’t it? and its worth every penny .

a- and its accrue to the buyer

It’s an European option, so the buyer will only have potential credit risk if the option is ITM. The premium is a pmt that has been made already, so how can it represent a risk?

def C…saw a CFAI similiar q…the credit risk is the market value of the option that you will lose if the counterparty goes under…to the person who said none if traded on clearing house shame on u for bringing reality into this

C. pimpineasy is correct. There is a CFAI EOC question just like this. The question is asking for CURRENT value of POTENTIAL credit risk, which is the current value of the option or $7

thanks for posting this …it really helps

inbead Wrote: ------------------------------------------------------- > C. pimpineasy is correct. There is a CFAI EOC > question just like this. > > The question is asking for CURRENT value of > POTENTIAL credit risk, which is the current value > of the option or $7 We are looking at the potential credit risk from the prospective of the call buyer, not the option itself. There is credit risk ONLY when the buyer is expected to receive a payoff. The option is OTM, so there is no payoff. Whether the seller goes under or not, the $7 has been paid already. How can the premium be at risk if it has already been paid?

dont mess with the CFA shun, the answer is C

What is at risk about this option? The premium which had been paid is like a sunk cost, so?

revisor Wrote: ------------------------------------------------------- > What is at risk about this option? > > The premium which had been paid is like a sunk > cost, so? Exactly, so it’s not at risk since it has been paid already.

lets say: you bought this option as a hedge; your counterparty defaults long before the expiry of the option and you need to replace this option with a new one to reconstitute the hedge. You will have to pay for the new option current value = premium. so the effect of credit risk is additional cost equal to premium of the new option.

I thought A because its out of the money, and the cost is sunk. But if the current value of the credit risk is the value if the counterparty goes under how would you answer this question? Greg buys a Call option. The strike price of this European option is $105 and the option sells for $7. Underlying is trading for 110. I would think that Greg has a credit risk of $5 (the amount in excess of strike). But under the assumption above, the credit risk would be 7+5=12. Thoughts?

pfcfaataf Wrote: ------------------------------------------------------- > lets say: you bought this option as a hedge; > your counterparty defaults long before the expiry > of the option and you need to replace this option > with a new one to reconstitute the hedge. You will > have to pay for the new option current value = > premium. > > so the effect of credit risk is additional cost > equal to premium of the new option. CFAI differentiates between potential credit risk and realized credit risk (I don’t remember the exact term). In that case, it would be not the potential credit risk regarding this option; when talked about potential risk, it is not certain whether the counterparty will default.

june2009 Wrote: ------------------------------------------------------- > I thought A because its out of the money, and the > cost is sunk. But if the current value of the > credit risk is the value if the counterparty goes > under how would you answer this question? > > Greg buys a Call option. The strike price of this > European option is $105 and the option sells for > $7. Underlying is trading for 110. > > I would think that Greg has a credit risk of $5 > (the amount in excess of strike). But under the > assumption above, the credit risk would be > 7+5=12. > > Thoughts? According to CFAI, the answer is $7. There is no point arguing with the guys that will grade your exam paper.