just to separate from the other post, after CSK comments on current vs potential credit risk in fwds, i just check one question in cfa, where somebody buys one european option credit risk = premium (ok) but current credit risk = 0 because it is not american, and only potential credit risk = premium I would have got it wrong in the exam. Easy, but tricky. Hope it helps
I think the defination of credit risk is itself problematic. That’s why it causing the problem.
one more: for european options, current credit risk = 0, potential credit risk = premium what about american? because of the reason for having current credit risk other than zero is that you can early exercise, this would mean that current credit risk = intrinsic value? I am looking for some examples in schweser and cfa, but found nothing thx
i will smile and then cry if this came up in the exam , a curve ball like this one i likely.
hala_madrid Wrote: ------------------------------------------------------- > just to separate from the other post, after CSK > comments on current vs potential credit risk in > fwds, > > i just check one question in cfa, where somebody > buys one european option > > credit risk = premium (ok) sorry but get confused. credit risk = premium? Does the other side need to pay you the premium if it’s in-the-money? say ---- (sample exam 3 Q23) Call bought for $30 (premium). Market quote for the option is now $35. I thought the credit risk is only $5 borne by the call owner?
The Call is In-The-Money so the seller must deliver $35 stock, the Buyer has a credit risk of $35 b/c the Seller can choose to ignore the deal and not deliver
Option MV is $35. I now. Ridicolous. But it is what it is
bigwilly Wrote: ------------------------------------------------------- > The Call is In-The-Money so the seller must > deliver $35 stock, the Buyer has a credit risk of > $35 b/c the Seller can choose to ignore the deal > and not deliver shxt. system error with my mind has caused to tell me that I am only getting what I earn from the counterparty @_@ thanks for fixing that
hala – i gave this some thought a while back and came to the same conclusion. the only concept of current credit risk i could think of for an american option would be intrinsic value. that would mean an itm american option has current credit risk, while an otm american option does not. bigwilly and csk, in the example given above, the market value of the option is $35, not the value of the underlying. if the call is itm, the premium will have an intrinsic value component and a time value component. i can see calling the intrinsic value component current credit risk, but not the time value component (the option seller doesn’t ever have to pay you the time value, just deliver the underlying). note that i’m not saying that the current credit risk = the spot price of the underlying. if you exercise, you have to pay the strike. saying the current credit risk = the price of the underlying would seem to ignore the fact that the long on the option has to pay the strike. once you pay the strike, then at that point you’ve got credit risk equal to the spot price of the underlying (or is that Herstatt risk…hmmm…)…but anyway, until you fork over the strike, i only see intrinsic value at risk. frankly, the whole current/potential distinction is a bit much… ps gotta find me some of those options that go up to $35…
Does the call premium represent credit risk? How so? He’s not owed any money either one way or the other. Not sure how this would represent credit risk if the option is out of the money.
the call gives you the right to buy, it doesnt give you the underlying. If you choose to exercise your right and PAY the strike you RECEIVE the underlying. The credit risk is not more than RECEIVE-PAY Credit risk associated with paying the strike and then not receiving the underlying is another type of credit risk Right?
call premium = credit risk to the long. Because his option, on average by option models, has ‘future value’ from the short position. Call premium is just the present value of the expected future value of the option at that particular time.
agree with elem that potential credit risk = MV of option (premium). but it’s if they ask about current credit risk that things get tricky. just looked it up in book 5 and found the statement that “with American options, current credit risk could arise if the option holder decides to exercise the option early”. to me this implies that they’ve actually reached the common sense conclusion that there is no current credit risk on an option until it’s exercised. at that point (once you fork over the premium) current credit risk = spot. until exercise, current credit risk = 0. oh, yeah, and this means my prior comments about current credit risk equalling intrinsic value for an american options would be…well, a lot of things…but correct would not be one of them…
elem100 Wrote: ------------------------------------------------------- > call premium = credit risk to the long. Because > his option, on average by option models, has > ‘future value’ from the short position. > > Call premium is just the present value of the > expected future value of the option at that > particular time. That makes sense… got it.
Max I believe that current credit risk = potential credit risk (ie rises from 0 to potential credit risk) upon exercise. Your argument that ‘you have paid the strike, so you are owed the underlying, thus credit risk is underlying (spot)’ is half correct imo in that of course at that time your credit risk is = spot. But it is not attributable to the option. The majority surely more of settlement risk/herstatt risk. If you remove the possibility of this (ie I pay but dont receive) then you are left with the potential profit on the position=premium as credit risk. Put another way, the only way your loss could be equal to the spot is if I wrote a call, you bought it off me, then come expiry you exercise the call but I say ‘ahahah I dont have any underlying to give you, in fact im bankrupt’, then you would not pay me the strike and your net loss would be =premium (at that time, = intrinsic value) only.
elem – completely agree. would be settlement/herstatt at that point, imo. was just trying to stretch this into some sort of concept of current vs potential credit risk during the life of the option since that’s where all this stuff comes up in the readings. and in reality this sort of default scenario could only happen with an otc option. if it ever happened with an exchange-traded option…well, there would probably be much bigger problems to worry about than settling up our $35 call…
OK, so only the buyer of the option faces credit risk, right?
yep, seller keeps the premium and has no credit exposure