CFA Text- Risk Mgmt (SS12)

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Volume 5- SS12- Reading 37- Page 75- Question 17
Ok…so our good friend Tony Smith buys a European Call option:
Underlying- $96
X Price- $101
Cost of Option- $6
What is the current value of potential credit risk?
I would say ZIP because that puppy is out of the money, but the book say’s $6 because thats what its selling for. Anybody else scratching their heads or am I the idiot?
 
Even though it is out of the money it still has time value as it could “Potentially ” move i,e the price might change by the time the option expires .
 
ok…so i am the idiot…now let me ask you this…Assume that the option was in the money by $10 (Stock at $111 & X price of 101)…would the “potential credit risk” be the $10 plus the cost of the option (lets just assume the cost stays at $6)…so $16?
 
Using their twisted logic thats what I would assume. I have to look I can swear I saw an example where the credit risk was only the “In money” portion
 
in that I think it would be 4= (10-6) which would be the payoff ….i cd be wrong though i;m not 100% sure
 
Yea..i mean they define credit risk as basically saying what is owed to you..what the seller may or may not be able to pay you on….thats why i’m like $6?…the seller isn’t going to default on the cost of the option…just doesnt make sense to me.
 
I would think thats the equivalent of taking the apples out of apple sauce
 
I understand CFAI logic. Before expiration, the option premium is given by both intrinsic value AND time value… if your counterparty defaults, you are losing not losing your intrinsic value, true, but you are losing your potential appreciation of the option
 
The potential credit risk is $6…
here’s why…would any of you give me this option right now for free? of course not, its worth six bucks right now and you want that money. NOW what happens if the corp. that issued the option enters bankruptcy? you as the holder of the option have the RIGHT to claim the options worth (six bucks) in court….
don’t get potential credit risk confused with current credit risk. American options can have current credit risk whereas european options only have potential until expiry.
this has been discussed here before as well - search the forum.
 
strikershank-
thanks for clearing that up. Going back to my other hypothetical question..if the option was in the money by $10..and cost $6…what would be the potential credit risk? $16? rudeboi suggested the payoff which was $4…..but wasn’t 100% sure.
 
the credit risk would be the value of the option at that point in time
if its in the money by $10, its intrinsic value is $10 but it also has time value as well, its impossible to know what the time value is in this hypothetical example, since no data is given, but lets say time value is $3, then credit risk is $13; the price of the option at that point of time would also be $13
 
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