7. Sam prices a put option with the Black-Scholes-Merton option pricing model and concludes the premium...

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7. Sam prices a put option with the Black-Scholes-Merton option pricing model and concludes the premium equal $25. The present value of expected exposure (EE) is $25 for this option. Sam estimates the PD of counterparty is 10%, loss given default is 40%. Hence, the CVA = $25 10% 40% = $1. He concludes that the CVA-adjusted (net of counterparty risk) option price is $24. His colleague Jane believes that this calculation assumes no wrong-way risk. Because there is a high, positive correlation between underlying asset price and the credit quality of the option writer (counterparty). Both the counterparty and underlying asset are in the same sector that reacts to some common factors such that adverse economic conditions depress sector asset prices while lowering sector credit quality (and increasing credit spreads). Is Jane correct that the CVA-adjusted option value deserves further adjustment? A. As long as the correlation is positive, this is right-way risk. But the CVA-adjusted value is $24 as there is no need for adjustment of right-way risk. B. As long as the correlation is positive, this is right-way risk; therefore, the true CVA-adjusted value will be higher than $24. C. Jane is correct that this is wrong-way risk; therefore, true CVA-adjusted value will be lower than $24. D. Jane is correct that this is wrong-way risk. But expected loss is not affected by correlation, so CVA-adjusted value is $24. 7. Sam prices a put option with the Black-Scholes-Merton option pricing model and concludes the premium equal $25. The present value of expected exposure (EE) is $25 for this option. Sam estimates the PD of counterparty is 10%, loss given default is 40%. Hence, the CVA = $25 10% 40% = $1. He concludes that the CVA-adjusted (net of counterparty risk) option price is $24. His colleague Jane believes that this calculation assumes no wrong-way risk. Because there is a high, positive correlation between underlying asset price and the credit quality of the option writer (counterparty). Both the counterparty and underlying asset are in the same sector that reacts to some common factors such that adverse economic conditions depress sector asset prices while lowering sector credit quality (and increasing credit spreads). Is Jane correct that the CVA-adjusted option value deserves further adjustment? A. As long as the correlation is positive, this is right-way risk. But the CVA-adjusted value is $24 as there is no need for adjustment of right-way risk. B. As long as the correlation is positive, this is right-way risk; therefore, the true CVA-adjusted value will be higher than $24. C. Jane is correct that this is wrong-way risk; therefore, true CVA-adjusted value will be lower than $24. D. Jane is correct that this is wrong-way risk. But expected loss is not affected by correlation, so CVA-adjusted value is $24.

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D Jane is correct that this is wrongway risk But expected loss is not affected by correlation so ... View the full answer