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LOS d: Evaluate credit risk in a forward contract, and explain how market value is a measure of the credit risk to a party in a forward contract. fficeffice" />

Q1. The best measure of the amount of credit risk exposure for a forward contract, at a point in time, is the:

A)   liabilities of the counterparty.

B)   value of the contract.

C)   notional amount of the contract.

Correct answer is B)

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.

 

Q2. The credit risk in a forward contract is:

A)   directly related to the contract value.

B)   positively related to the term of the contract.

C)   only an issue for the long.

Correct answer is 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.

 

Q3. Over the life of a forward contract, the amount of credit risk is least likely to:

A)   stay the same.

B)   change signs.

C)   increase.

Correct answer is 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.

 

Q4. 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)   contract value to the short is negative and decreasing.

C)   settlement date is getting closer.

Correct answer is C)

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.