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 setup of the forward contract. A forward is an agreement to buy at a fixed price F0 at maturity T. Here F0 = 104 (derived from the initial conditions with S0 = 100 and r = 4%), and the current time is 9 months into the contract, with 3 months remaining until maturity. The current spot price is S_t = 101.50.

Option A: The long. To assess the value to the long, compute the mark-to-market value of the forward position. The intrinsic value at the current time is V = (S_t − F0) discounted to the present value if necessary. Numerically, S_t − F0 = 101.50 − 104 = −2.50. Since the remaining time to maturity is 0.25 years and the risk-free rate is 4%, the present value factor is roughly e^{−rt} ≈ e^{−0.04×0.25} ≈ e^{−0.01} ≈ 0.990. Thus V_long ≈ −2.50 × 0.990 ≈ −2.48. A negative value means the long is in a position where they would owe about $2.48 at settlement, subject to counterparty performance. In other words, the long has negative value and would be at risk from the counterparty not meeting obligations, i.e., the long bears the credit exposure in this contract.

Option B: The short. If the long owes money at settlement, the short is the recipient of that payment. In a default scenario where the counterparty (the long) may fail to deliver or pay, the short would stand to lose from the default, meaning the short would be exposed to credit risk only if they were owed money and the counterparty failed to pay. However, because the current value to the long is negative, the short is the recipient of a payment from the long at settlement, not the one who bears the risk of nonpayment. Therefore, the short’s primary concern would be recoveries in the event of the long’s default, but the immediate credit exposure is to the long.

Putting it together, the contract’s current mark-to-market valuation shows the long has negative value, implying the long owes the short at settlement, which creates credit risk for the long (the party with negative value) more than for the short. The structure of a forward transfers potential credit risk to the party that would owe money if the contract is in-the-money for the other party, which is the long in this setup.

In summary, Option A is the statement that aligns with the typical credit exposure dynamics of a forward contract at this point in time: the long bears the credit risk. The reasoning rests on the fact that a negative value to the long implies an obligation to pay if the agreement is honored, exposing the long to counterparty default risk, whereas the short would be the recipient of that payment and is less exposed in the event of their counterparty default.

BU.232.750.81.FA25 Final Exam Fall 2025- Requires Respondus LockDown Browser

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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_______

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