credit risk on options?

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mambovipi

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Hey - couple of q’s
1) are the premiums paid/recevied seen as a part of the credit risk on an option?
2) what is the credit risk on an american ITM option coming up to expiry (say 1 month to exp)?
Cheers
 
Here’s my understanding on point one. Please someone correct me if I’m wrong- premiums are paid/recieved at the inception of the contract and thus are not considered a part of credit risk.
 
Premium are not considered (why? You´ve already paid for them. There is not risk for any party since it´s already settled).
Now, the credit risk is:
- short position: none
- long position: value of the option, assuming it could be exercised today. Example: imagine that you buy a 1-month call, ITM, with a strike price of $20 and current value of underlying is $22. Thus, your credit risk is $2.
Please correct me if I´m wrong.
 
If the option is in the money, Long has credit risk due to having a position position. If the option is out of the money, no credit risk exists as the option will expire.
 
A key component of risk is uncertainty: if it ain’t uncertain, it ain’t risky.
As the premium has already been paid, it isn’t uncertain; thus, it isn’t part of the risk.
The uncertainty to the long is that they will choose to exercise the option and the short won’t deliver.
The uncertainty to the short is the at the option will move in the money and be exercised.
 
“If the option is in the money, Long has credit risk due to having a position position. If the option is out of the money, no credit risk exists as the option will expire.”
Not quite true . The option still has time value , so the long party bears some credit risk
 
The book says value of option will be credit risk to long. But then they give an example that according Black Sholes the current value is 8.55. So that is our credit risk.
So there I get confused, as B&S calculate the price of an option. Is that the same as the current market premium?
 
The long has potential credit risk equal to the value of the option because they could choose to sell it for that price and the buyer might default.
 
Related question -
A European option has no current credit risk.
If it is worth $5 right now and expires in a month, what is its potential credit risk?
 
Whaaaaaaaaaat? No fancy calculations involving the risk-free rate like that for a swap?
Well, didn’t see any in the textbook so for the next 11 days, it’s a moot point :)
 
1recho wrote:Whaaaaaaaaaat? No fancy calculations involving the risk-free rate like that for a swap?
Well, didn’t see any in the textbook so for the next 11 days, it’s a moot point :)
Click to expand...
By gosh, you’re right!
Let’s see … it’s worth $5 today. So … discounting at the risk-free rate back to today … zero days … gives us … Oh, wait … .
 
I think the way it works with options is very much different say compared to forwards because of the asymmetric payoff. Even out of money option have value because of the concept of time value. Thus by simply discounting back does not yield the actual value because it does not consider time value amount.
Thus for such instances it seem like the best solution would be take the difference b/w stike and spot price as value?
 
The call option value is max (0, S - X) + time value which is nonzero till it expires. Not just max (0, S - X).
Anyway, even I know that the present value of a future spot price is…. the current spot price.
 
i can’t quite see my quesiton answered in all the above. Let’s exclude the premium.
So for a EU ITM option what’s the credit risk to the Long prior to expiry? The intrinsic value is what it is however can change considerably from now until maturity. At maturity the credit risk is obivously the intrinsic value.
For an AMERICAN ITM option you could argue the same, even though the option is ITM, depending on when the Long choses to excercise it could go OTM or even increase in value even more.
Basically do you consider the intrinsic value as the credit risk?
 
Basically, for any option, at any time, the value of the option (which is the present value of the future payoff accounted for volaitility, time, etc) is the current credit risk for any purchaser because that is the potential value payoff if the EU contract ends abruptly due to the seller defaulting or an American option is exercised today, the seller of the option has to buy/sell at the excercise price.
So to answer your question - yes. The current option value is the current credit risk to the buyer.
 
Wouldn’t it depend on whether or not the options are standardized-exchanged contracts backed by a clearinghouse versus OTC option contracts?
Exchange traded options are guaranteed by the OCC, very similar to how futures are guaranteed. So they have zero credit risk. Even if the short fails to deliver the underlying asset the clearinghouse will step in and assume the other side of the trade. The original counter party could default, but you will still receive payment regardless. i.e. equity stock options traded through the CBOE
Non-standardized option contracts would be susceptible to credit risk at any point in the contract’s life if they are American style. I believe European options would only have credit risk on the day of expiration because you couldn’t exercise at any point before that date.
 
guys don’t overthink. if the value of the option in the open market is $5, it will already incorporate intrinsic value or discounting in the event of a european option. that option is only valuable if the other party honours it (the seller). so if the seller defaults or goes bankrupt then you can’t sell that option or exercise it. you have lost something worth $5 even if the intrinsic value is 0 or les than $5.
 
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