Reading 62: LOS d ～ Q1- 4

1.The credit risk in a forward contract is:

A)   directly related to the contract value.

B)   only an issue for the long.

C)   not important in T-bill forwards.

D)   positively related to the term of the contract.

The correct answer was A)

The credit risk to the party with the position with the positive value (long or short) is greater, the greater the value of the forward contract at a point in time. A contract with a longer term may have a lower contract value. It is not related to the default risk of the underlying asset.

2.The best measure of the amount of credit risk exposure for a forward contract, at a point in time, is the:

A)   notional amount of the contract.

B)   margin deposit.

C)   liabilities of the counterparty.

D)   value of the contract.

The correct answer was D)

The amount of credit risk is best measured by the contract value at a point in time. This is the present value of the settlement payment, based on current market prices, interest rates, or exchange rates. The party to whom the payment would be made has the credit risk, the risk that the payment will not be made or that the asset will not be delivered/purchased at contract expiration.

3.Credit risk to the long (position) in a forward contract will increase over the life of the contract due to all of the following EXCEPT the:

A)   short party has deteriorating finances.

B)   settlement date is getting closer.

C)   contract value to the short is negative and decreasing.

D)   value of the underlying asset is above the contract price and increasing.

The correct answer was B)

Deteriorating finances of the counterparty increase the probability of default. The amount owed to the long increases as the value of the underlying asset increases, which is the same as an increase in the value of the contract. An increase in the amount ‘owed’ and an increase in the probability of default can both be viewed as increasing credit risk. By itself, the passage of time does not necessarily increase credit risk.

4.Over the life of a forward contract, the amount of credit risk is least likely to:

A)   stay the same.

B)   increase.

C)   decrease.

D)   change signs.

The correct answer was A)

The amount of credit risk is least likely to stay the same. The amount of credit risk is based on the contract value, which is zero at contract initiation. For the value to stay the same (at zero), the expected future price of the asset must not change over the life of the contract, an unlikely circumstance. As the value of the contract to the long goes from positive to negative, the amount of credit risk changes in sign.