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A trader purchases a six month over-the-counter straddle on stock A for a 1 Million premium from a counterparty. The maximum credit exposure over the life of the trade is:

1)less than 1 Million.

2)between 0.5 Million-1 Million.

3)exactly 1 Million.

4)greater than 1 Million.

My answer is 3) but author says 4) is correct answer.

How is that?

3 Answers 3

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"Credit exposure" means "What is your exposure should the trade go your way and the other side does not pay up?" Since you own the straddle you stand to make more than what you paid (otherwise you wouldn't buy the straddle), so your maximum credit exposure is greater than 1 Million.

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  • It's a poorly worded question because we have to "interpret" what is being asked. Feb 15 at 16:06
  • "Credit exposure" is a pretty common term for your exposure to a counterparty defaulting. I've reworded it to make it sound less like a guess.
    – D Stanley
    Feb 15 at 16:14
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    I don't have an issue with your answer. It's the question's wording that is bothersome to me. Feb 15 at 16:16
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The risk to the buyer of a straddle is the amount paid (ignoring Exercise By Exception screw ups at expiration in the USA). The seller's risk is greater than that of the buyer.

The maximum credit exposure over the life of the trade is:

This wording of the question is subject to interpretation. My take is that the question is asking about the exposure of the one who is receiving the credit which means the straddle seller. Therefore, the answer would be:

4)greater than 1 Million

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Straddles are volatility strategies because they are based on the expectation of high or low volatility rather than the direction of the stock price. The straddle is designed to capitalize on high stock price volatility. To create a profit, the stock price must move substantially in either direction. It is not necessary to know which way the stock price will go; It is necessary only that it make a significant move.

In our question, if the stock A price six month down the line goes up substantially, seller of the Over The Counter straddlle would prefer to sell his stock A in the market rather than selling the stock A to the trader as contracted ; because market will fetch him better price. Therefore, he may default.

Similarly, in case, price of the stock A goes down substantially six months down the line, seller of the Over The Counter straddle may choose to default because he would find it attractive to buy the stock A from the market at lower price, instead of honouring the contact.

This way, towards both the directions of stock price, trader purchasing the Over The Counter straddle is exposed to greater than 1 million credit risk/counterparty risk.

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