Quiz - Potential Credit Risk particular, currently, believes, potential, next

jbaldyga

Tony Smith believes the price of a particular underlying, currently selling at $96, will increase substantially in the next 6 months, so he purchases a European call option expiring in 6 months. The call option has an excercise price of $101 and sells for $6.

What is the current value of potential credit risk? (Also an explanation of why if you can)

NakedPuts00

SerGrey Wrote:
-------------------------------------------------------
> Right, but then for call buyer $6 will be price
> risk, not credit risk (becouse the other party
> doesn't have an obligation to pay $6 back).
> I am finally confused...

Market risk and credit risk are opposite to each other. Market risk is a risk that you will lose money due to adverse market moves. Credit risk is a risk that you will make money in the markets but the counter party will not pay off your gains. Let's look at the situation with an option. If A sells a call option to B for $6. A recieves $6 immediately and has no credit risk because there is no situation when B would owe anything to A. However, A's market risk is unlimited because if asset goes up to big time the call pay off will be very high. On the contrary, B's market risk is limited to the premium of $6 that he has already paid but the credit risk he is facing is huge because potentially call option can be very valuable if markets go up. Then current credit risk and potential credit risk are ways of looking at short term and long term credit risk of the position. Does that help?

ohai

What about the wording in $35 example??

> Given - "A call option the bank purchased from a
> dealer for $30. The current market price of the
> option is $35"
>
> For the Banks long call option position, the most
> appropriate estimate of the amount of risk of a
> credit loss is
>

"the most appropriate estimate of the amount of risk of a credit loss is..."

why is potential CR most apropriate estimate?? what if probability of default is very low?

NakedPuts2011

potential credit risk = MV of the option.

the MV of the option already takes into account the spot and strike.

you have not paid the 96, so there is no credit risk there. But you have paid $6. If the option goes to 12 a month from now, then your potential creidt risk is 12.

PalacioHill

it is not consistent, isn't it.

follow the 35 logic, the credit risk should be 96+6 = 102, as you risk on losing holding of this IMPLIED amount?

anyone understand this totally and can explain to a client in plain language?

infinitybenzo

CFAdreams Wrote:
-------------------------------------------------------
> Tony Smith believes the price of a particular
> underlying, currently selling at $96, will
> increase substantially in the next 6 months, so he
> purchases a European call option expiring in 6
> months. The call option has an excercise price of
> $101 and sells for $6.
>
> What is the current value of potential credit
> risk? (Also an explanation of why if you can)

$6, because you've basically loaned the writer of the option $6 for their promise to pay you the face value of that option at an unspecified point in time.

Should that point in time be 5 minutes after you've purchased it, they would theoretically pay you $6 back, which is the BSM price of said option.

dyga

30 is strike. It's from 2010 mock.

mik82

LaGrandeFinale Wrote:
-------------------------------------------------------
> Related question:
>
> Given - "A call option the bank purchased from a
> dealer for $30. The current market price of the
> option is $35"
>
> For the Banks long call option position, the most
> appropriate estimate of the amount of risk of a
> credit loss is
>
> A. $0
> B. $35
> C. $30


35



Edited 1 time(s). Last edit at Saturday, May 29, 2010 at 02:43PM by pupdawg82.

lcai

is the stock price or the call option price $30? If the strike price is $30, then, $35 is the corect answer, but if the Q is as you stated, then, I don't know how you can get to the answer.

NakedPuts00

Related question:

Given - "A call option the bank purchased from a dealer for $30. The current market price of the option is $35"

For the Banks long call option position, the most appropriate estimate of the amount of risk of a credit loss is

A. $0
B. $35
C. $30