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Why a Dealer’s Short OTC Option Is a Balance-Sheet Liability

Article Quant Q&A · Author: Vinter
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Summary

The note explains how an over-the-counter option sold by a bank is generally viewed from the dealer’s perspective. After receiving the premium, the dealer has a contract that may require future cash payments, so a short option position is treated as a liability. Under the accounting framing discussed, the derivative liability is measured at fair value through profit and loss, meaning changes in its value affect reported earnings.

The answer relates this treatment to the idea that a financial instrument creates an asset for one party and a corresponding liability or equity instrument for another. It also notes that the premium is intended to cover hedging costs and provide a margin. The explanation is simplified: collateral or margin cash flows are excluded, and the precise balance-sheet line depends on the bank’s reporting presentation. The document’s example points to negative market values of derivative instruments within financial liabilities measured at fair value through profit or loss.

Key ideas

  • A dealer’s short OTC option is generally a liability because it can require future cash outflows.
  • The option liability is expected to be recognized at fair value through profit and loss.
  • Changes in the fair value of the liability affect the dealer’s reported profit or loss.
  • The option premium is intended to cover hedging costs and leave a profit margin.
  • The explanation excludes collateral and margin-related cash flows.

Tags

OptionsDerivatives pricingRisk management
Full text
# A bank sells a put and a call - where does it show up in the book? Asset or Liability


# A bank sells a put and a call - where does it show up in the book? Asset or Liability












I have some difficulties seeing where financial products show up in banks balancesheets?

For example if I buy a put and a call option OTC from a bank, will it be an Asset or a liability from the banks perspective?

Thanks guys, hope it is not a silly question.

## Answer by afekz (score 2)

https://quant.stackexchange.com/a/29713

For any dealer in OTC options, a short option position represents a liability, since, after receiving the initial payment, that contract offers only potential cash outflows.[1]

To use an IFRS definition, a liability is:

- a present obligation

- arising from a past event

- the settlement of which is expected to lead to an outflow of future economic benefits from the entity.

I'd expect these liabilities to be recognised at "fair value through profit and loss", i.e. variations in the option liability would generate profit or loss.

To emphasise the point: IAS32 defines a "financial instrument" as "a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity".

The hope of the dealer is that the option premium received is sufficient to cover the costs of hedging that position plus a profit margin.

[1] Ignoring any margining / collateral-type cash flows.

Edit: have a look at Deutsche Bank's 2015 balance sheet at https://annualreport.deutsche-bank.com/2015/ar/financial-statements/consolidated-balance-sheet.html

If DB had sold you an OTC option, I'd expect the option position to be reflected in the line "Financial liabilities at fair value through profit or loss", in the sub-item "Negative market values from derivative financial instruments".

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.