In question 21 in CFA book - end of Reading 40, the answer argues that the losing party in a currency forward contract does not have credit risk. While I would agree for most other contracts, my understanding is that currency forward contract are not netted and the principal is exchanged in both currencies and in both directions ; hence both parties have credit risk. What do you think?
yep I’m with you - credit risk would be highest toward expiry - because both still must exchange principal currency amounts at the end. Winning side has highest credit risk toward expiry. Losing party has less - but not nil, I would have thought.
My 2 cents … Currency forward contract is a zero sum game. Both sides have equal value collateral in the begining (exchanged principals). If one side looses, it has more valuable collateral , than its required payoff. So, it doesn’t have credit risk. The winning side has credit risk because, its collateral is insufficient to cover its payoff from the contract.
GetSetGo Wrote: ------------------------------------------------------- > My 2 cents … > > Currency forward contract is a zero sum game. Both > sides have equal value collateral in the begining > (exchanged principals). If one side looses, it has > more valuable collateral , than its required > payoff. So, it doesn’t have credit risk. The > winning side has credit risk because, its > collateral is insufficient to cover its payoff > from the contract. that would be a swap and not a forward, right ??? anyway, the simple logic is the losing side can go to the market to buy/sell and by definition the market price is better than the forward contract price(since he/she ended up on the losing side). So, he/she doesn’t hold any credit risk. He is still good(even better) if the winning counterparty defaults.
fsa-sucker: I apologise. (That shows how prepared i am doesn’t it ? ). This cirriculum is slippery.
olivier Wrote: ------------------------------------------------------- > In question 21 in CFA book - end of Reading 40, > the answer argues that the losing party in a > currency forward contract does not have credit > risk. That statement is absolutely correct. Let’s think about it. If A buys a forward contract from a B and A is the losing party (i.e. A owes money to B), A has no credit risk. You can only have credit risk if the other party owes you money (and decides not to pay you).
maratikus Wrote: ------------------------------------------------------- > That statement is absolutely correct. Let’s think > about it. If A buys a forward contract from a B > and A is the losing party (i.e. A owes money to > B), A has no credit risk. You can only have > credit risk if the other party owes you money (and > decides not to pay you). I agree with you in most forward contracts, but for currency forward contracts I think the notional principals are exchanged instead of netted, which would introduce credit risk to both parties of a currency forward contract. I’m also in agreement with olivier. Can anyone shed some light?
fsa-sucker Wrote: ------------------------------------------------------- > anyway, the simple logic is the losing side can go > to the market to buy/sell and by definition the > market price is better than the forward contract > price(since he/she ended up on the losing side). > So, he/she doesn’t hold any credit risk. He is > still good(even better) if the winning > counterparty defaults. Ahh OK this explanation works for me.
i think Olivia got confused between currency swap and currency forward. currency swap both sides exchanged the principal at the beginning. However, currency forward is one side agreed to buy/sell a currency for exchange of another currency at a fixed price so there is no principal exchange at the beginning. The winner will bear the credit risk at the expiry.
Speaking of which - did anyone look at Schweser’s example of this (Page 188/9 of Volume 4) and calculate the credit risk as the change in the value of the fwd contract? The provided calculation doesn’t look very intuitive. The rationale was which party would be disadvantaged by transacting in the spot market. I would understand this if it was at contract expiration, but it states that the time in question is 3 months into a 6 month contract. I computed the value of a new fwd contract (int rates and spot is provided) and noted that the diff was 3500 (not the 3509 they come up with). Am I off base on this?