Risk Management

Taken from morning session 2008- Evaluate credit risk

  • Redriver shorts a two year forward contract on JPY denomininated in ZAR at 15.00 JPY/ZAR forward rate
  • Forward expires today
  • Exchange rate was 14.5 JPY/ZAR when Redriver entered the contract
  • Spot (current) rate is now 17.50 JPY/ZAR
  • Compound annual interest rate for the two year period : 1% in JPY and 10% in ZAR

Which of the part bears the credit risk and why?

Rediver bears the credit risk since he long the ZAR in the forward, and now ZAR appreciate to 17.5 comparing 15 in the forward contract.

Rediver shorts JPY forward contract for 15 JPY/ZAR

Say he had short JPY 1500 & locked in at forward to receive 1500 / 15 = ZAR 100

Now spot (current) rate is JPY 17.50/ ZAR = he would only receive 1500 /17.50 = ZAR 85.71

So he bears the credit rsik that counterparty may not deliver ZAR at forward rate

Counterparty bears the credit risk. Contract was written in ZAR so he owes .0666 ZAR/JPY and receives .0571 ZAR/JPY.

I think redriver bears the credit risk. The redriver shorts the Japanese yen denominated in ZAR, so at the expiration of the future, he will sell 1 JPY and receive 0.0666 ZAR. The current value of the JPY he is selling is 0.0571 ZAR, so he is owed money and thus is bearing credit risk.

counter party bears risk

short forward payoff:

(Contract forward price - current spot)

15-17.5 is negative. meaning he has negative cash flow and owes counterparty.

Redriver is SHORT the call - so he writes it…his only credit risk is getting the premium from the counterparty

Once he gets the premium he can no longer bear risk since he will never be owed any more money in the future

the coutnerparty (who is long) is the only party who bears risk because he’s the only party that can ever be owed money

there is no reason to do any calculation on this question

mcap, this is for a forward contract, not a call option.

HAHA - my bad - i just reviewed the question earlier in the week and got ahead of myself

time for a nap

Redriver short Yen (at forward price 15Y/R)

Now, Yen depreciate (17Y/R) -> Redriver take profit

-> Redriver bear credit risk

I agree with truongdv

Red is short the forward so if it depreciates he is better off

it depreciated, so he now in the money

in the money = he bears credit risk of other side not paying him

damn i got it wrong.

correct answer is Redriver bears risk

CFAI answer guideline

“Based on the comparison between the forward rate 15.00 JPY/ZAR and the spot rate 17.50 JPY/ZAR, the short-yen counterparty (RR) receives the payment, so RR bears the credit risk.”

Short forward payoff = F[t]-S[t]=1/15-1/17.5=0.0667-0.0571=0.0096

Forward contract has a positive value to the short,short bears the Credit risk that the long does not pay.