Extrinsic option value: Credit risk

[vola]

Hi all,



if I have an option with an extrinsic value as of today would I see this as a credit exposure? It is about a long-term contract and the option gives the holder the right either to purchase a vessel or to prolong the contract.



Thanks

[Cheng]

Maybe I can help but can you provide some more details ? I stumbled three times across "extrinsic value", perhaps I'm getting old.

[vola]

Our front office says that as long as the option is not in the money (extrinsic), we do not need to account this as a credit risk. My argumentation is that the option has a MtM as of today not matter if in or out of the money. Therefore I need to put this on top of my settlement risk.



What is the problem with extrinsic?



Cheers

[vola]

And do I have a MtM if I rent a vessel and the charter rate (the price) is completely floating? Basically, I wonder how to set up a limit for a deal where the contractual price is floating.

We are talking about time charter. You pay 5 days after B/L for total 15 days and you have 10 days exposure. I would assume that the price is fixed on 5th day. Does it mean that I am running MtM risk for 10 days?



Thanks

[Cheng]

I never heard "extrinsic" in that context (or never at all to be precise). Anyway.



Our front office says that as long as the option is not in the money (extrinsic), we do not need to account this as a credit risk. My argumentation is that the option has a MtM as of today not matter if in or out of the money. Therefore I need to put this on top of my settlement risk.



You have credit risk if MtM is in your favor. If your counterparty defaults and MtM is positive from your point of view you have to pay to re-enter the contract. But that's probably already in your settlement risk. Besides that, yes, if the option is in the money and the underlying asset owner defaults you also loose, ie you also have credit risk (think of an ITM call where the underlying company defaults and the stock jumps close to 0).



We are talking about time charter. You pay 5 days after B/L for total 15 days and you have 10 days exposure. I would assume that the price is fixed on 5th day. Does it mean that I am running MtM risk for 10 days?



If prices can change in the meanwhile, yes. But is this really the case ? Or do you just lock in a price that will remain fixed and you have "only" settlement risk ? Or putting it the other way round, if new prices arrive, are they related to your original contract terms or to different ones (like settlements farther in the future) ?

[Nonius]

just adding onto Cheng.



if the option is done under margin calls, in all cases you have exposure to your counterpart, no matter whether you buy from or sell to that counterparty.



if the option is sold with no margin calls, e.g. sold "outside of a CSA", then there's no credit exposure.



if the option is purchased with no margin calls, e.g. purchased "outside of a CSA" then there is credit exposure.



on your second question, you'd need to give more details on the question.

[sfca]

"if the option is sold with no margin calls, e.g. sold "outside of a CSA", then there's no credit exposure"



What if its a swaption, you sold the right to enter an interest rate swap, they exercise that option, and you find you have an interest rate swap against Joe's Bar and Grill for $300MM.  Isn't that credit exposure?

[silverside]

That it is



You can have hours of fun with CVA, FVA, and DVA



You could make life easier by insisting on cash settlement (or include early termination clauses)



Or you could end up with several dozen bushels of wheat in the vestry

[Nonius]

Zup?

[vola]

We are talking about physical deal where we charter (lease) a vessel with an option (real option) to buy it. We do not pay any premium in advance. The options is not in the money but I suppose that due to the time value effect it still can have a positive MtM?



Nobody will (be willing to) margin this under CSA lol or even charge a CVA