Mock 2014 Item Set 9

CFA Level III Derivatives
#1

Call option has a strike of $65 and was purchased at a price of $3.50 per option. The option’s current value is $8.5 per option. Current Stock price $70.

  1. What is the credit risk of the option if it is American from Buyer’s perspective?

My Ans:

a) Current Option Value is $8.5, so credit risk = $8.5.

b) 3.5 was paid as a premium at the contract initiation; that amount is gone already. Currently, I am at risk of loosing 5 if seller doesn’t oblige. So, credit risk = $5.

Both these answers conflict.

  1. What is the current and potential credit risk of the option if it is European from Buyer’s perspective?

Current Credit Risk = 0 since settlement will happen on the future date.

But how to calculate potential credit risk? Using Risk-free rate?

Please clarify these doubts.

Thanks!

#2

You stand to lose 8.5 if they don’t pay. The beginning premium you may is irrelevant. If they don’t pay tou, you lose 8.5. You don’t get back 3.5 if they don’t pay you, so there is no way it would be 5.

I don’t really think we ever use a discount rate for payoff for options (someone should correct me if I am mistaken). The potential risk is the value of the option, so 8.5.

#3

current credit risk for european is 0

potential is also 8.5