Maple Leaf is long 100 JPY put European style options with expiration in 6 months, at strike prices of 100 JPY/CAD and a contract size of JPY12.5 million. Current exchange rage is 102.5 JPY/CAD. Six-monrh interest rate is given at 3% for Canada and 0.5% for Japan. Question asks for the amount at risk from a credit loss on the long JPY put option.
I get that Maple leaf is the party that bears credit risk because it bears the risk that the other party won’t make the payment to buy the option in 6 months.
However, in claculating the amonut, of loss, the solution uses 1/100 -1/ 102.5 and say “if exchange rates remain unchaged until then”.
My question is why we don’t use the interest rates to calculate the actual future exchange rate in 6 months: 100*1.005^0.5/1.03^0.5?.
for part 1, when we calculate credit risk for forward contract, we need to know the future exchange rate. Why for options, do we use current market value to calculate the amount at risk from a credit loss?
Your credit risk is the net present value of what you will receive if that is positive, or zero if that net present value is negative.
For options, the present value is positive only if you have the long position, and then only if the option is in the money; the amount of credit risk is the amount that it is in the money.
For forwards, the (net) present value is the present value of what you will receive minus the present value of what you will pay. If you have the long position, then the present value of what you will receive is today’s spot price today, and the present value of what you will pay is the present value of the (known) forward price. If you have the short position, then the present value of what you will receive is the present value of the (known) forward price, and the present value of what you will pay is today’s spot price.
This is the stuff of which Level II derivatives is made.