credit risk on forward contract

Q:

Assume there is a 1-yr forward contract at \$106 with the risk free rate of 5% and it is 3 months into the life of this contract. The spot market is at \$104. Determine any cash flow owed between the parties, assuming mark to market every 3 months.

A:

\$104 - \$106 / (1.05^(9/12)) = \$1.8087

Short owes the long this amount.

I’m not fundamentally understanding why the short owest his money to the long. If the contract is worth the discounted value of \$102.1913, then isn’t the person who is long the forward contract losing and the person who wrote (short) the contract winning on the trade? I guess I’m not visualizing why this is a payment by short to long, and not vice versa.

Imagine you want to lock in the price of a security at a forward price (106) in one year, this means you are willing to pay 106 (i.e.long) in one year’s time when the contract matures…now move forward 3 months time, you discount the 106 you have to pay in 9 months time to figure out the Present value of the 106…so, as the long position you would hypothestically need to pay 102.1913 to the counter party…the counter party gives you the security that is worth 104.

Hence : Long owes short 102.1913 & Short owes long 104…long bears the credit risk that the short will not commit to the contract.

thx very much alladin. my brain is not working today. i appreciate it!

Is this question from EOC, or somewhere else?

I’ve seen questions on the credit risks of currency forward, swap, and options. The forward contract looks testable also.

Check out Study Session 14 - Risk Mgmt. There is a blue box example on credit risk in forwards and swaps. I believe there are also EOC questions too.