Suppose a forward contract that expires in one year is available on an asset that is currently worth $100 and the risk-free rate is 4%, the forward price is 100x1.04 = 104. It is now nine months later, and the asset is worth $101.50. The value to the long and amount of the credit risk is_______

Who bears the credit risk in the forward contract ?

Question

Suppose a forward contract that expires in one year is available on an asset that is currently worth $100 and the risk-free rate is 4%, the forward price is 100x1.04 = 104. It is now nine months later, and the asset is worth $101.50. The value to the long and amount of the credit risk is_______

Who bears the credit risk in the forward contract ?

BlackTom AI · Accepted Answer

We start by identifying the remaining time to expiry and the current forward price for the contract.
- Original forward price agreed at inception: 104 for 1 year.
- Nine months have passed, so 3 months remain to expiry (T − t = 0.25 years).
- The current spot price is S_t = 101.50.
- The forward price for the remaining 0.25 year period, assuming a risk-free rate r = 4% annualized, is F_t = S_t × (1 + r)^{0.25} ≈ 101.50 × (1.04)^{0.25} ≈ 101.50 × 1.0098 ≈ 102.9.

Now, the value of a forward to the long (the buyer) is usually V_long = S_t − F_t. Substituting, V_long ≈ 101.50 − 102.9 ≈ −1.4. This means the long position is currently in a negative value position: if settled today, the long would owe about 1.4 to the short.

With a forward, the party that would incur a loss if the other party defaults is the one who is in-the-money from the perspective of the contract, i.e., the party that would receive money (or avoid paying money) if the contract is settled. Since V_long is negative, the short is effectively in the money (the short would be owed money by the long at settlement). Therefore, the credit risk (the risk that the counterparty defaults) is borne by the short in this scenario, meaning the long has no immediate obligation to the short in terms of credit exposure; rather, the short holds the exposure to potential default by the long.

Option analysis:
- A. The long: This would be incorrect because the long’s value is negative (approx −1.4), indicating the long would owe the short if settled, not that the long has the credit risk exposure.
- B. The short: This is correct because, given V_long < 0, the short stands to benefit from the contract but also bears the counterparty’s (long’s) default risk; hence the credit risk is associated with the party that would receive payment if the contract remains in the money for the other party.

In summary, the current valuation implies the short is the counterparty with the credit exposure in this particular moment for a forward with a negative value to the long.

BU.232.750.51.FA25 Final Exam Fall 2025- Requires Respondus LockDown Browser

View Explanation

Log in for full answers

Similar Questions

Suppose a forward contract that expires in one year is available on an asset that is currently worth $100 and the risk-free rate is 4%, the forward price is 100x1.04 = 104. It is now nine months later, and the asset is worth $101.50. The value to the long and amount of the credit risk is_______

More Practical Tools for Students Powered by AI Study Helper

Homework AI Solver

Stylized AI Paper Writer

Plagiarism Checker Assistant

Citation AI Academic Writing Tool

In-Class Translation Assistant

AI Note Generator

AI Quiz Answers

Past Exam Questions from University Test Bank

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler