Credit Loss

[itsyourz]

Hi,

this is a question from 06 practice exam part II

79.Which of these transactions will NOT result in a credit loss for Bank A in the event of
default before maturity by Bank A’s counterparty?

I. Bank A buys an ATM (at-the-money) call option on the USD/CHF and the
CHF subsequently depreciates against the USD.
II. Bank A buys an interest rate cap and interest rates are below the cap level.
III. Bank A goes long AUD through an OTC forward contract on the AUD/YEN
and the AUD subsequently appreciates against the YEN.
IV. Bank A receives fixed in an interest rate swap and interest rates have risen.

II and IV is the right answer, but i'm wondering about I and III

first, in terms of choice I,
it says CHF depreciation against USD, which makes USD/CHF go down
so call option is gonna be OTM. this is my thought
however, this is what solution gives -> It would result in a credit exposure as the option has moved in-themoney
and has a positive value to Bank A.

next one, choice III
it says long AUD through forward on the AUD/YEN
I thought forward price in this contract is AUD/YEN
so that there will be a loss (but not credit loss) if AUD appreciates against yen ; AUD/YEN goes down

It would result in a loss as the contract has a positive value to Bank A -> this is explanation by garp
how does contract have positive value??

thanks a lot

suk

 

[David Harper CFA FRM]

Hi suk,

Regarding I, if the call option is say, $0.80 USD/CHF and CHF appreciates, then exchange rate goes up to, say $0.90 USD/CHF (i.e., a single CHF buys more dollars; dollar depreciates b/c it requires more dollars to buy a single CHF). So, this option moves in the money

Regarding III, answer looks okay here too. The forward is long the currency that is appreciating.

so the question is saying, for those transactions that are profitable (i.e., positive value) the BANK A is incurring credit risk (negative value doesn't matter).

David