The failure mechanics of dealer banks

[Imad]

Hi David,

Hope you are well.
Can you please explain below comment:
"a counterparty may also request to receive cash from options positions that are in-the-money by having them revised to at-the-money".

Thanks
Imad

 

[ShaktiRathore]

Hi Imad, David might give explanation later but according to my understanding if you like it,
counter party might want to cash in the ITM options so that there is no credit risk in case the counter party may have large ITM position. By having cashing in ITM options and converting them to ATM options the counter party reduces the exposure and thus reduces the credit risk. By revising the option the overall value of counter-party position in form of option remains unchanged but at the same time reduces risk of other counter party not fulfilling its obligation in time.
If value of ITM option: value=max(S-X,0)=S-X =>exposure=S-X
converting to ATM option: value=max(S-S,0)=0=>exposure=0
so overall exposure reduces by S-X and at the same time counter party has money safe in its pocket.
The flexibility of counter-party converting options positions that are in-the-money by having them revised to at-the-money gives additional power to the counter-party.
thanks