Skip to content

FRM Part II · FRM Exam Part II · Derivatives

An airline buys oil call options from a commodity trading firm to hedge fuel costs. The trading firm's creditworthiness deteriorates when oil prices fall. From the airline's viewpoint, which statement is most accurate regarding counterparty risk on the calls?

This is right-way risk. The airline's calls carry exposure when oil prices are high, which is when the trading firm is healthier and less likely to default. Exposure and default probability move in opposite directions, so an independence-based CVA would overstate the risk.

  1. AIt is right-way risk, since the calls are valuable when oil is high, a time when the trading firm is financially strongerCorrect
  2. BIt is specific wrong-way risk, since calls lose value when the trading firm is weak
  3. CIt is wrong-way risk, since oil price rises always increase the trading firm's default probability
  4. DThere is no dependence, because option exposure depends only on strike

Explanation

The calls are in the money, giving the airline exposure, when oil is high. The trading firm is stronger then, so default probability is low when exposure is high. That is right-way risk, and CVA assuming independence would overstate the charge.

Did you get it right without looking?

One question tells you little. A timed set on Derivatives shows your real accuracy, how long you take and where you lose marks.

Practise DerivativesFree diagnostic mock

More Derivatives questions