Counterparty Credit Risk and American Options

Abstract

This paper analyzes the effect of counterparty credit risk on optimal early exercise policy and value of American options. In contrast with the existing literature we find that the price of the underlying asset at which it is optimal to exercise an American option 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 such expected credit loss. 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.