credit exposure for an option position

[Kavita.bhangdia]

Hi David,

I am little confused with the exposure calculation for an option.
1. If I buy a call with a strike of 100 and my underlying is 110 at maturity, it should mean that my exposure is 10 right..

And if I have bought a put with a strike of 100 and the underlying is at 90 at maturity, my exposure would be 10..

is that my credit exposure.. I read somewhere ( not sure though) that for options, their is no credit risk, it is basically settlement risk..

Is that true..

Thanks,
Kavita

 

[David Harper CFA FRM]

Hi @Kavita.bhangdia

You are correct. Current credit exposure is given by max(MtM, 0), or as the FRM handbook has it, CE = Max[V(t), 0], and therefore cannot be negative; current credit exposure is the risk you won't realize your gain. So if I write (sell) you the put to which you refer (strike = 100), and the option expires out of the money (e.g., stock price = 110), then you will have no credit exposure because you have no gain to lose. Just as you say, on the other hand, if the stock price goes to $90.00, at expiration, you'll have an unrealized gain (or intrinsic value) of +10, and until you are paid (settled) you have credit exposure of +10.

However, notice something further. What about the instant you buy the put option from me: it will have immediate positive value, +V(t), due to the time value (even if the intrinsic value is zero). So, you have some non-zero credit exposure immediately; and the credit exposure profile is a projection into the future of your potential gains such that is an upward sloping line, which recognizes the probabilistic opportunity for you to expire in the money. What about me, who wrote you the option? I collected the premium, so I really do not have any credit exposure because the risk of needing to pay you is a negative to me, such that from my perspective your gain is Max[-V(t), 0] = 0. I hope that helps!

 

[Kavita.bhangdia]

Thanks David