Workshop Series: Peter Klein
This paper analyzes the effect of counterparty credit risk on optimal early exercise policy and valuation of American options. In contrast with the existing literature we find that the optimal early exercise policy can be significantly different when there is counterparty credit risk. We show that it is not always optimal to exercise when a credit event is likely yet it is sometimes optimal to exercise for credit reasons even when the risk of a credit event is fairly remote. Further, we find that discounting the expected payoff on American options at a higher credit-risk-adjusted rate may lead to inaccurate valuation results. Numerical examples illustrate that early exercise can mitigate only approximately one third of the expected credit loss for American options. This result conflicts with the existing literature that claims early exercise can largely eliminate it. The remaining expected credit loss can be attributed to two sources: the write-down of the payoff if financial distress occurs; and the loss of time value if early exercise was motivated by credit concerns.
Dr. Peter Klein is a professor of finance. Prior to joining the Beedie School of Business, he spent 10 years in a variety of senior roles at CIBC/Wood Gundy Financial Products, including chief trader for capital markets in London, UK and vice-president of investment banking in Tokyo. He then made a career switch, earning his PhD in finance from the University of Toronto in 1996 before arriving at SFU. In 1998, he received the Faculty's highest teaching honour, the Canada Trust Distinguished Teaching Award. Peter was the founding academic director of the faculty's Global Asset and Wealth Management MBA and continues to teach in this program.
A former trustee of the SFU academic pension plan, Peter is also a Chartered Financial Analyst, Chartered Business Valuator, Certified General Accountant and was previously director of professional development for the Vancouver Society of Financial Analysts.
Peter focuses his research on return anomalies, taxation, credit risk, derivative securities and corporate governance and has published in a number of leading academic journals, including the Journal of Financial Economics, the Journal of Public Economics and the Journal of Banking and Finance.