Credit Risk and Forward Contracts

There is credit risk involved in forward contract because the counterpart may not deliver the asset to you at the time of delivery.

Since a forward contract is not exchange traded, a buyer or seller cannot lock in gains/losses on the contract’s value prior to the agreed settlement date. The contract must be held till its maturity.

Credit Risk Amount: Given this characteristic of forwards, the contract’s value serves as a quantification of credit risk for the counterparties involved in the contract.

Expected Loss: The expected loss on a forward contract is equal to the notional amount of the contract multiplied by the contract’s value multiplied by the probability of default.

If the contract has a positive value, then the buyer is at risk that the seller will not deliver the underlying at settlement.

If the contract has a negative value, then the seller is at risk that the buyer will not purchase the underlying at settlement.