The answer is clearly A because we know they are wrrong on the option, and it is the only one with a NO
however they state that he is wrrong regrading the forward, how did they find that out, they only have the current spot rate but we need the interest rates to determine the proper forward price or they need to tell us the forward price.
Kalton agreed to buy pound at Euro 1.45/ pound
current spot rate is Euro 1.40/ pound…that is need lower euros to buy pound than in the forward. Counterparty bears the risk that Kalton may not fulfill his obligations to buy pounds @1.45
I agree with brokercfa . There was a Schweser question on the same lines in Book 2 or exams ( PM # 2, I think ) , that tested the same thing , but showed the forward same as the spot. Of course I fell for it , in declaring there was no credit risk . The right answer is that since interest rates are almost always positive , the present value of the forward is less than the spot , so the buyer of the forward is having a credit risk with respect to the dealer.
In this question , I was wondering the same thing as brokercfa , which is in the absence of the interest rate , and fowrad and spot being different , how do you know the present value of the forward ? It seems highly fishy not to mention that , and also not to mention if it is a present value or the contract value of the forward !
Jana
I tried to check this kind of question in SCH Practise exam 2 book in PM sections which you are refering to here…Can you quote the #?
this question in the book specifically is EXPIRING on that day.
“The first position is a long forward currency contract to buy pounds at ˆ1.4500. The current exchange rate is ˆ1.4000 per pound.”
So St = 1.40 and F = 1.45
and St - F will be what the long’s value will be and because it is negative - Short owes Long, so Long bears the credit risk.
Is the Schweser question you are talking about this one?
Cramer includes the following:
A forward contract sold has 6 months to delivery, contract price = 50. Underlying has no cash flows or storage costs and is currently priced at 50. No funds exchanged up front.
Question asks:
a. contract has current credit risk.
b. contract has potential credit risk
c. contract has neither potential nor current credit risk
it does not have any current credit risk.
but it has potential credit risk - since St - F/(1+r)^t will be either positive or negative.
If negative - firm has to pay - so counterparty bears credit risk. If positive - firm will receive and so firm bears credit risk.
where does it say expiring today ?
expiring was the wrong term to use. they are asking to evaluate the “current” … just like you did a X-St on the Put option …
but you did not do x-st for the put, you looked at the value of the position which is represented by the price of the option
following the same thought for teh futures we should be looking be subtracting the presnt value of the futures price from the spot price
it it was a futures contract the the position would be worth st-f, but this is a forward…
???
for futures prices its S - F/(1+r)^n
for futures on exchange rates its S/(1+f)^n - F/(1+d)^n
^ dont you mean forwards
is not a future worth s-f only since they are marked daily
They are marked daily , yes . But the spot is equal to the futures only on the expiration day. For all other days it is a time value of money calculation so practically it is the same as a forward on present value calculation. The “current” credit risk would have to factor in the risk free rate for both forward and futures .Clearly the schweser test question ( yes , CPK found the right one) is on the right track while CFAI forgets to account for interest rates . The answer may still be the same , but there is no calculation to prove it.
BTW look at Example 8 on Page 255 , Volume 5 for a spot or current credit risk example. They clearly use the interest rates to do a PV calculation . Then how come not for this question ?
^ but since we are marking to market daily, dont you discount the pay off you can get at the end of the day for only 1 days interest which is nealry nothing, once the future is market to market, you can essentialy offset it with an identical future but with opposite position which at that time would be the fair value of the future…
point being you can exit it at a total cost of f-s0 which is the mark to market, and then you enter into offsetting transaction?
Anyway the futures contract eliminates credit risk to the owed party completely , since the credit risk is absorbed by the exchange ( they try and offset it daily as you said , but only up to the margin amount , not required to put up the whole notional every day )
Anyhow if you see a credit risk question involving futures start laughing heartily
the question did not ask HOW MUCH is the credit risk. For that you need the “interest rates”.
They asked who bore the credit risk given the present condition.
Given the forward was 1.45 and current spot is 1.40 - I who am long the contract is better off by going to the market and getting it at 1.40. So the counterparty expecting a payment of 1.45 will not get it. So he bears the credit risk.
But he gets the payment only on expiry , right ? Present value of that payment is less than 1.45 . How much less is not clearly known , which is the whole point .
If rates are high , you can get the present value below 1.40 even , then the credit risk would shift from counterparty to you
current
The word current is not used , neither in the itemset nor in the question . Only in the answer , and in that one too it is written “current prices” , which would imply spot . The foward rate does depend on spot but also on interest rates.
cpk with all due respect i am still no on the same page
you have the forward price, and you have the spot, but in order to know who owes who, and who is at risk, we need to know interest rates
at a large rate the 1.45 will be discounted to become less than te 1.4, and thus the long has the ability to buy at a price with PV less than the spot and thus he is the winner and he is the one facing the risk
at a small interest rate thge pv of 1.45 will be greater than 1.4, and thus the long is stuck having to pay for more than the spot price in PV terms, and he is the one that owes money, and thus the short is the one facing risk
^ which is exactly what janakisri said in ten times less space, better work on my explanation skills for the exam
everywhere they say “is bearing the credit risk”.
what does that mean.