Does selling a call option also counterparty risk free?

[lianne]

Hello, we know that selling a put option has no counterparty risk as you would be expecting to pay only.
How does selling call option work?

Thanks!

 

[David Harper CFA FRM]

Hi @lianne

On a basic level, I think it's the same: writing (selling) an option collects the premium up-front such that the counterparty, who is long, incurs the credit risk, but not the short. While the credit risk to the long differs between call (unlimited) and put (limited), and also depends on right-way and wrong-way risk (the classic example is a put option on a counterparty's own asset value: the put value increases as the counterparty's value decreases), in both cases the short (if the short has received the premium) is free of credit risk. I hope that helps!

 

[lianne]

Hi @lianne

On a basic level, I think it's the same: writing (selling) an option collects the premium up-front such that the counterparty, who is long, incurs the credit risk, but not the short. While the credit risk to the long differs between call (unlimited) and put (limited), and also depends on right-way and wrong-way risk (the classic example is a put option on a counterparty's own asset value: the put value increases as the counterparty's value decreases), in both cases the short (if the short has received the premium) is free of credit risk. I hope that helps!

That makes sense.
Thank you, David!

 

[bultai]

Thanks David.
Its been some time. Just a follow up on the above response.
If premiums are paid on a forward basis (not upfront), will you still say sold options don't attract CCR? Also, another question was, if premiums are paid on a forward basis, the EAD as per Basel is M2M + Net PFE. So will the unpaid premium reflected in M2M? In this case, since we can ascertain with certainty the magnitude of the cash flow (unpaid premium), is this more credit risk (like loans exposure) rather than a derivative?
See this below FAQ link from EBA. It says solo sold options doesn't attract CCR. However, does it include both cases where premiums are paid up-front or paid at maturity?

http://www.eba.europa.eu/single-rule-book-qa/-/qna/view/publicId/2015_2195


Many thanks in advance

Sam

 

[Eltanariel]

From my point of view, as long as you are expecting to receive a payment in the future, then you attract CCR as you face the risk to not being paid. Now looking at the EBA FAQ, I interpret that point only for standard option which have the payment upfront and not more customized options with forward payment.

 

[bultai]

From my point of view, as long as you are expecting to receive a payment in the future, then you attract CCR as you face the risk to not being paid. Now looking at the EBA FAQ, I interpret that point only for standard option which have the payment upfront and not more customized options with forward payment.

Thanks Eltanariel

In that case what would be the m2m calc from sellers perspective?would the premium amount be reflected as the positive m2m and PFE of 0?
Thanks

 

[Eltanariel]

In fact for an option not in a netting set you have 2 possibilities:
- the option will be exercised and will cost you something
- the option is not exercised and will be worthless
So to be conservative, your credit exposure is the discounted premium (and your MtM will be the sum of your discounted premium and the option value which is negative for the writer)

 

[bultai]

Thanks Eltanariel.
Would there be any Potential future exposure (PFE) in this case?

Thanks

 

[Eltanariel]

As long as you have EE you'll have a PFE so in the case of an option with a forward premium you have a PFE for a given confidence level, but I'm not sure if I answer really the question you want to ask

 

[bultai]

Thanks Eltanariel.
Much appreciated.

 

[Merlinius]

Hi, I know this is an old thread but my colleague and I were just discussing this. A short option with late delivery and physical settlement clearly has counterparty credit risk, do you agree? If the counterparty exercises, we will be exposed to the underlying which might carry CCR. Another example would be a short swaption. If the swaption is exercised, we will be left with a swap which has counterparty credit risk. Am I seeing this correctly?

 

[Eustice_Langham]

In fact for an option not in a netting set you have 2 possibilities:
- the option will be exercised and will cost you something
- the option is not exercised and will be worthless
So to be conservative, your credit exposure is the discounted premium (and your MtM will be the sum of your discounted premium and the option value which is negative for the writer)

Interesting thread...what is the significance of the netting set and would this sold option potentially invoke wrong way risk?

 

[Eustice_Langham]

I

Hi, I know this is an old thread but my colleague and I were just discussing this. A short option with late delivery and physical settlement clearly has counterparty credit risk, do you agree? If the counterparty exercises, we will be exposed to the underlying which might carry CCR. Another example would be a short swaption. If the swaption is exercised, we will be left with a swap which has counterparty credit risk. Am I seeing this correctly?

If the premium is deferred then yes, there will be CCR, and potential MTM revaluation issues