# Credit Risk

Question:

An investor goes long on a fwd contract established at \$105 that expires in 1 year and the risk free rate is 4.25%.

It is now 6 months into the contract:

1. what is the current and potential credit risk and which party asumes the credit risk at:

A. current price of \$100

B. current price of \$105

c. current price of \$110

this is from memory so i am probably wrong, but S x e^(r*t) = 107.255, which is what it’s worth in 6 months, so if the current price is \$100 he has no credit risk, the other party has the risk that he wont pay of \$107.255 - \$100 or 7.255, for B.) it’s the other party again for \$2.25, and fo c.) the risk is his at \$110-107.255 at \$2.745

The contract is worth 105 at expiration in 6 months, today it is worth 105/[(1+.0425)^.5] = 102.84. If current price is 100 then the long investor assumes the credit risk that the CP will not pay. at 105 and 110 the CP assumes the credit risk.

I agree with Fin Ninja, and you can see it in Risk Management: Reading 6.2.2 (Reducing Credit Risk by Marking to Market), Forward contracts are established at the price they will be, so we need to work backwards to find the price it is at 6 months.

On a side note, some forwards are marked to market and then at the 6 month time the two parties would settle and establsh a new forward price moving forward.

Good question.

Forwards are usually not marked two market. Futures are, though.

There’s also some Credit Risk questions on the 2009 morning session that involve calculating derivative positions. I wasn’t ready for it - needed to go back and refresh.

I was just reading this stuff from CFA book today. On page 253 in CFAI book similar example…

I’d answer that in case A, short is actually bearing potential credit risk. Long is holding claim with PV of 102.84, when spot is 100.

so MV for long is 100-102.84= - 2.84, MV for short +2.84.

For B&C, long bears credit risk, MV positive for him/her.

Check out p. 253, it’s similar, but “who’s bearing credit risk” contradicts with what the opinion is here.

When Asset is priced at 100 - the Long’s position is 100 - 102.84 = -2.84.

So Long would actually owe the short 2.84 . so Short bears the potential credit risk. Rocci is right in this aspect.

for b) and c) - the Long’s position is 105 - 102.84 and 110 - 102.84.

In both these cases - the Short owes money to the Long. If the Short declares bankruptcy - he would owe that money to the long. But if the long declared bankruptcy - he would have an asset worth that amount. So LOng bears the potential credit risk in these cases.

Rocci is right.

Rocci - I think you are right. I just looked in the book and it does show current market value of the position = Spot - PV of FWD.

For a negative market value for the long position, the CP would bear the credit risk that the long will default.

Good catch, I’m still trying to work these out!

The long pays \$\$\$ to take delivery at the term.

If he has to pay more dollars than the contract is worth , the short bears the risk.

If he has to pay less dollars than the contract is worth , he ( i.e. long ) bears the risk.

Contract is worth spot*(1+r)^t.

If Fwd price > Contract is worth then short bears the risk ( short is smiling and worried )

if Fwd price < Contract is worth then long bears the risk ( long is smiling and worried )

Always look at who is smiling . That’s the guy who bears the credit risk and can’t sleep at night.

there is also other way of understanding this:

Identify who is better off in the spot market, opposite party to him bears the credit risk

for a) Current price = 100 PV of frwrd = 102.84

so long party is better off in the spot market (i.e. his stock whose CMP is only 100 but he has agreed to pay for this by going long at 102.84 - so he would happy in the spot market if not got long in the frwrd market) - Opposite party (i.e. short party) will bear the credit risk.

for B) & C) long is getting the stock cheaper in frwrd market than the spot market so short party is better off in spot market. Opposite party to short (i.e. long party) bears the credit risk

Another way to understand -

Look out for the one who can make money by closing frwrd contract & doing transaction in spot market

i…e CMP 100 PV of frwrd 102.84

short party will close the frwrd at 102.84 to long & will buy the stock in spot only for \$ 100. He will gain \$2.84 so he bears the credit risk if long party defaults & shows his unableness to honor the obligation for buying stock at agreed frwrd rate.

for B & C - long party can make gain by closing frwrd contract & seling the stock in spot. So he bears the credit risk