The effect of counterparty credit risk on American options, July 14, 2014, Peter Klein, Beedie School of Business Professor of Finance
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The effect of counterparty credit risk on American options, July 14, 2014
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...