LOS b, (Part 2): Discuss how termination alternatives prior to expiration can affect credit risk.

Q1. When a party to a forward contract terminates the contract prior to the original expiration date by entering into a perfectly offsetting forward contract with a second counterparty:

A)   there is no future liability, but default risk remains for all parties until the original contract settlement date.

B)   the party terminating the contract is exposed to default risk, but has no further asset price risk.

C)   the party terminating the forward contract has no default risk, but both counterparties face default risk.

Q2. An investor can exit a forward position prior to contract expiration by all of the following methods EXCEPT:

A)   making a cash payment or accepting a cash payment by agreement with the original counterparty.

B)   entering into an offsetting contract with the original counterparty.

C)   exercising the early delivery option.

Q3. Which of the following is NOT a method of terminating a forward contract prior to expiration?

A)   Exercise a swaption.

B)   Make an agreed upon payment to the counterparty.

C)   Enter into an offsetting forward contract with the original counterparty.

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Q1. When a party to a forward contract terminates the contract prior to the original expiration date by entering into a perfectly offsetting forward contract with a second counterparty:

A)   there is no future liability, but default risk remains for all parties until the original contract settlement date.

B)   the party terminating the contract is exposed to default risk, but has no further asset price risk.

C)   the party terminating the forward contract has no default risk, but both counterparties face default risk.

Correct answer is B)

When a forward contract is terminated by an offsetting contract with a second counterparty, there is no further asset price risk, but since there are two separate contracts with different counterparties, all parties are exposed to default risk until both contracts are settled. Since the two contracts may have different forward prices, the terminating party may have a future liability at settlement, but the amount is fixed at the time the offsetting contract is initiated. The terminating party may have ‘locked in’ a future gain or loss, depending on the difference between the forward prices of the two offsetting contracts.

Q2. An investor can exit a forward position prior to contract expiration by all of the following methods EXCEPT:

A)   making a cash payment or accepting a cash payment by agreement with the original counterparty.

B)   entering into an offsetting contract with the original counterparty.

C)   exercising the early delivery option.

Correct answer is C)        

There is typically no early delivery option in a forward contract. The other two methods are both usual ways of terminating a forward contract prior to the settlement date specified in the contract.

Q3. Which of the following is NOT a method of terminating a forward contract prior to expiration?

A)   Exercise a swaption.

B)   Make an agreed upon payment to the counterparty.

C)   Enter into an offsetting forward contract with the original counterparty.

Correct answer is A)

A swaption can be used to terminate a swap. The others are both ways to terminate a forward contract prior to expiration.

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