There is credit risk involved in forward contract because the counterpart may not deliver the asset to you at the time of delivery.
Since a forward contract is not exchange traded, a buyer or seller cannot lock in gains/losses on the contract’s value prior to the agreed settlement date. The contract must be held till its maturity.
Credit Risk Amount: Given this characteristic of forwards, the contract’s value serves as a quantification of credit risk for the counterparties involved in the contract.
Expected Loss: The expected loss on a forward contract is equal to the notional amount of the contract multiplied by the contract’s value multiplied by the probability of default.
If the contract has a positive value, then the buyer is at risk that the seller will not deliver the underlying at settlement.
If the contract has a negative value, then the seller is at risk that the buyer will not purchase the underlying at settlement.
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Let's break down the key concepts mentioned in the article:
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Credit Risk in Forward Contracts: Forward contracts are private agreements between two parties to buy or sell an asset at a predetermined price and date in the future. One significant concern in forward contracts is credit risk, which refers to the risk that one of the counterparties involved may not fulfill their obligations. In other words, they may fail to deliver the asset or make the payment as agreed upon.
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Non-Exchange Traded Nature: Unlike futures contracts, forward contracts are not exchange-traded. This means that there is no standardized marketplace where these contracts can be bought or sold. Instead, they are customized agreements between two parties. This lack of exchange trading makes it challenging to lock in gains or losses on the contract's value before the settlement date.
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Holding until Maturity: Another characteristic of forward contracts is that they must be held until their maturity date. Unlike exchange-traded futures, which can be offset or closed out before maturity, forward contracts do not offer this flexibility.
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Credit Risk Amount: The value of a forward contract serves as a quantification of credit risk for the parties involved. This means that the contract's worth represents the potential loss that one party may face if the other party defaults on the agreement.
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Expected Loss: The expected loss on a forward contract can be calculated by multiplying the notional amount of the contract by the contract's value and then by the probability of default. This formula helps quantify the potential financial exposure due to credit risk.
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Positive and Negative Value: If a forward contract has a positive value, it implies that the buyer is at risk because there is a chance that the seller will not deliver the underlying asset at the agreed settlement date. On the other hand, if the contract has a negative value, it means that the seller is at risk because there is a possibility that the buyer will not purchase the underlying asset at settlement.
In summary, credit risk is a significant concern in forward contracts due to their non-exchange traded nature and the requirement to hold them until maturity. The contract's value is a key indicator of credit risk exposure, and the expected loss can be calculated using a specific formula. Understanding whether a forward contract has a positive or negative value helps assess which party is at risk in the event of a default. Effective risk management and mitigation strategies are essential when dealing with forward contracts to minimize potential losses associated with credit risk.
