Financial Risk Manager Part 2
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In the context of financial risk management, consider a trading firm that has entered into a transaction involving a European-style call option, specifically tied to stock JK. The crucial details of this option are as follows: it has a 9-month expiration period, a strike price set at EUR 45, an underlying asset price of EUR 67, and an implied annual volatility of 27%. Additionally, the annual risk-free interest rate is 2.5%. Based on this information, what is the credit exposure to the trading firm's counterparty from this transaction?
In the context of financial risk management, consider a trading firm that has entered into a transaction involving a European-style call option, specifically tied to stock JK. The crucial details of this option are as follows: it has a 9-month expiration period, a strike price set at EUR 45, an underlying asset price of EUR 67, and an implied annual volatility of 27%. Additionally, the annual risk-free interest rate is 2.5%. Based on this information, what is the credit exposure to the trading firm's counterparty from this transaction?
Explanation:
The correct answer is A. Selling an option exposes the firm to zero counterparty credit risk as the premium is paid up front. This means that the trading firm has already received the premium for selling the European-style call option on stock JK, and therefore, there is no credit risk associated with the counterparty defaulting on their obligation. The counterparty credit exposure from this transaction is EUR 0, as the firm has already been compensated for the potential future payoff of the option. However, if the firm were buying an option, it would be exposed to counterparty credit risk, as it would be relying on the counterparty to fulfill their obligation in the future. The other pieces of information provided, such as the time to expiration, strike price, underlying asset price, and implied annual volatility, are relevant for pricing the option but are not necessary for determining the counterparty credit exposure in this case.