Capital requirements on over the counter options

Abstract

Over the counter (OTC) options involve both market and counterparty risk. Capital requirements are imposed on options to cover these risks and prevent systemic failures that may arise as a result of widespread defaults. This paper demonstrates that the default risk attached to these instruments can be modelled as a contingent claim instrument, that is, as a default premium, and, as such, capital requirement imposed on OTC options should be based on the objective of covering this premium. The capital requirements, as suggested by this paper, can be applied to either or both the writer and buyer of the option such that the possibility of default is negligible.