The Credit Risk of Complex Options

Abstract

In Chapter 3 we have reviewed methods of quantifying the risk of standard put and call options and in Chapter 4 we have discussed the nature and risk of various compound option strategies. In this chapter we explore the nature, use and risk of complex options; while such options were regarded as rather esoteric only a few years ago, most are becoming increasingly commonplace in today’s financial markets. Complex options are defined as derivatives with structural enhancements which result in payoff or protection profiles which are different from those obtained with vanilla puts and calls; the structural differences can relate to the nature and determination of the payoff path, the commencement of the option, the timing of the premium payment, the establishment of the strike price, and so on. Given the differences between vanilla and complex options many of the risk features are distinct from those discussed in the previous chapter and warrant closer examination. Indeed, certain derivatives described in this chapter carry substantial amounts of credit risk; credit officers evaluating the appropriateness of such deals must be fully aware of the credit exposures assumed when executing such transactions.