Financial Risk Manager Part 2
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To fully comprehend and solve the task at hand, let's delve into some background information on the key concepts involved:
In the context of derivatives trading, a European-style call option is a type of financial contract that provides the buyer with the right, but not the obligation, to purchase the underlying asset at a specified strike price on the option's expiration date. In this scenario, we need to analyze the credit exposure faced by the counterparty involved in selling such an option. Credit exposure refers to the risk of financial loss that the counterparty could face if the trading firm defaults on the agreement.
Let's consider the following specific details provided:
- Option Type: European-style call option
- Underlying Stock: JKJ
- Expiration: 9 months from the current date
- Strike Price: EUR 45
- Current Asset Price: EUR 67
- Implied Volatility: 27%
- Annual Risk-Free Rate: 2.5%
Using these details, calculate the credit exposure to the trading firm's counterparty in this transaction.
To fully comprehend and solve the task at hand, let's delve into some background information on the key concepts involved:
In the context of derivatives trading, a European-style call option is a type of financial contract that provides the buyer with the right, but not the obligation, to purchase the underlying asset at a specified strike price on the option's expiration date. In this scenario, we need to analyze the credit exposure faced by the counterparty involved in selling such an option. Credit exposure refers to the risk of financial loss that the counterparty could face if the trading firm defaults on the agreement.
Let's consider the following specific details provided:
- Option Type: European-style call option
- Underlying Stock: JKJ
- Expiration: 9 months from the current date
- Strike Price: EUR 45
- Current Asset Price: EUR 67
- Implied Volatility: 27%
- Annual Risk-Free Rate: 2.5%
Using these details, calculate the credit exposure to the trading firm's counterparty in this transaction.
Explanation:
The correct answer is A, which indicates that the trading firm's counterparty credit exposure from selling a European-style call option on stock JKJ is zero euros. This is because when a firm sells an option, it receives the premium upfront, which eliminates the counterparty credit risk. The counterparty credit risk arises when the firm is on the buying side of an option, as it would then be exposed to the risk of the counterparty defaulting on their obligations. In this scenario, since the firm is selling the option, it is not exposed to any credit risk from the transaction. The other details provided, such as the time to expiration, strike price, underlying asset price, implied annual volatility, and annual risk-free interest rate, are relevant for pricing the option but are not necessary for determining the counterparty credit exposure in this case.