Kalton Corporation has two large derivatives positions with a London securities house. The first position is a long forward currency contract to buy pounds at €1.4500. The current exchange rate is €1.4000 per pound.
Who is bearing the credit risks?
Answer:
For the currency forward contract, the London securities house is bearing credit risk because the London house is the party that would be owed (or paid) at current prices.
But I think neither bears current credit risk because this contract is not at expiration. Regarding to the potential credit risk, we cannot tell who bears potential credit risk because the question does not tell us the forward exchange rate at current time. So, we do not know the current market value of the contract and we do not know the sign as well, which means we do not know who owes who.
Properly, they should have given you either the forward rate today or the risk-free rates for EUR and GBP.
However, this isn’t Level II: you’re not expected to discount the future exchange rate and compare it to the spot rate. This is Level III, and all they want you to do is understand that if Party A likely owes money to Party B, then Party B bears the credit risk.
There are some small calculations in L3 curriculum to see which side currently has a gain and credit risk, but there were only a few of them.
The potential credit risk always lies on the company with that would be paid if the contract ended today. If both parties would be paid (currency swap) both bear credit risk, etc.
For this question, I know we do not need to calculate the amount of market value of the contract. But we need to know the sign in order to know who owns who. If positive, Kalton bears potential credit risk. If negative, securities house bears potential credit risk. The current spot rate seems useless because the contract does not expiry today. This question does not provide us thoes information. Am I right?
You want to compare the spot rate to the discounted contracted forward rate, so the spot rate is most definitely _ not _ useless. (Recall your Level II.)
Just compare the spot rate to the contracted forward rate and leave it at that. Forget about the discounting.
I recall from level 2 we have to discount forward rate to get the market value, right? Maybe this question is not very strict. Normally we cannot compare spot rate and forward rate without discounting.
The side which have a positive exposure always bears a credit risk. Doesn’t matter if contract is not expired yet. The size of such exposure depends on contract maturity phase. The side which have a positive exposure is the one to whom other side owes the money.
Credit risk is higher at bilateral forward contract than on marked traded FUT contracts with Central clearing system and marking to market on frequent basis. The all risk reduction is exactly in collateral coverage and quality of collateral.