The EBA has published different Q&As on the application of the Mark-to-Market method to sold options including Q&A 2013_666 and Q&A 2015_2195. Sold options are examples of derivatives whose market value will never exceed a specific amount. This amount is equal to zero if the full premium is paid at inception of the transaction or equal to the amount of unpaid future premiums if the total premium is paid over time or at the end of the option contract. Consequently, the potential future exposure (PFE) for these derivatives will never exceed the aforementioned amounts. The previous guidance provided by the EBA as part of the Q&A process is not conclusive regarding the treatment of sold options that form part of a larger netting set for the purpose of calculating the PFE add-on under the Mark-to-Market method.

A)    Existing EBA guidance on the PFE add-on calculation of sold options in specific situations

1.     Q&A 2013_666 confirms that a sold option that forms part of a larger netting set (i.e. a netting set that also includes other types of derivatives) must be included in the PFE add-on calculation for the netting set because the (absolute) market value of the sold option may decrease and hence the replacement cost of the netting set may increase.

2.     Q&A 2015_2195 confirms that for (standalone) sold options that do not form part of a larger netting set the PFE add-on is zero because their market value will never be positive. Whilst the existing Q&As concern the PFE add-on calculation of sold options in specific situations, with this Q&A we would like to confirm the underlying general principles for the treatment of sold options to ensure a consistent application of the Mark-to-Market method to sold options in all relevant situations.

B)    Proposed general principles for the PFE add-on calculation of sold options

We outline the proposed general principles for the PFE add-on calculation of sold options below. They distinguish between standalone sold options and those which form part of a larger netting set. The proposed general principles are consistent with the existing EBA guidance for specific situations as outlined above.

1. PFE add-on calculation for standalone sold options

The PFE add-on for standalone sold options should not exceed the maximum possible exposure that may result from the option. For sold options where the full premium is paid up-front this treatment has already been confirmed through Q&A 2015_2195. For sold options where the premium is paid over time or at the end of the option contract, the maximum possible exposure will never exceed the amount of unpaid premiums. Hence, in this case the PFE add-on should not exceed the amount of unpaid premiums which equals the maximum possible exposure.

2. PFE add-on calculation for sold options included in a larger netting set

The PFE add-on for sold options that form part of a larger netting set should not exceed the maximum possible exposure increase of the netting set that may result from the option. This principle is consistent with Q&A 2013_666 which states that sold options contribute to the PFE add-on. The Q&A refers to the specific example of a netting set composed of an interest rate swap with a market value of 100 and a sold option with a market value of -30. The Q&A clarifies that the inclusion of the sold option in the PFE add-on calculation is required because the market value of the netting set may increase due to a potential “decrease of the fair value of the sold option”. It acknowledges that the market value of the sold option will never exceed zero. Accordingly, as per the existing Q&A, the PFE add-on for the sold option should not exceed 30 in the example, which corresponds to the maximum possible exposure increase of the netting set that may result from the sold option with a negative market value of -30.