The effect of counterparty credit risk on American options

Beedie School of Business Professor of Finance Peter Klein.

New research from the Beedie School of Business suggests that long-established practice used by financial institutions for over two decades is in fact inaccurate – and could have major repercussions for the way banks value assets.

The study, “Counterparty Credit Risk and American Options”, was conducted by Beedie School of Business Professor of Finance Peter Klein and Beedie MSc Finance alumnus Jun Yang. It was published in the summer 2013 edition of the Journal of Derivatives.

The researchers examined the effect of counterparty credit risk – the risk to each party in a contract that the counterparty will not live up to its contractual obligations – on optimal exercise policy and valuation of American style options. Contrary to previous research on the subject, they found that optimal exercise policy can significantly affect the critical asset price at which early exercise of a vulnerable American option is optimal.

Owners of American style options may exercise that option at any time before it expires, unlike European style options, which can only be exercised at expiration. The major accounting standards boards around the world have long since adopted the results from the previous research when dealing with American style options.

However Klein and Yang’s research indicates that when dealing with American style options this previous research is simply incorrect, resulting in inefficient pricing strategies being utilized by financial institutions.

“The research shows that the accounting standards boards of the world banks have it wrong – the banks really aren’t organized correctly to properly manage credit risk in the American style options,” says Klein.

“The specific issue that arises is whether the early default barrier, which depends on the price of the underlying asset and the time to maturity, also depends on the degree to which there is credit risk in the writer of the option,” explains Klein. “The previous research paper that has been used so much in the industry says that it does not depend on that. But what our research shows is that it does in fact depend on that. You are really looking at the effect of credit risk incorrectly unless you take this factor into account.”

The researchers found that it is not always optimal to exercise for credit reasons even when the risk of a credit event – any sudden and tangible negative change in a borrower’s credit standing or decline in credit rating – is fairly remote.They also found that discounting the expected payoff on American options at a higher credit-risk-adjusted rate could lead to inaccurate valuation results.

“Typically, credit risk in a bank is managed independently from the market risk inherent in an options position,” says Klein. “But what this paper shows is that you are throwing away a lot of value if you are managing this independently, and that the trader has to trade his hedge differently because of the effect of credit risk.”

Should banks implement the findings of the research into their practice, they stand to make significant gains – including greater pricing accuracy, and better understanding of what the true value of an option they are purchasing is. “It offers banks a tremendous pricing advantage in the market,” Klein says.