In a forward contract, both parties are required to fulfill their obligation on the expiration date. Then what would happen if a counterparty wants to exit its position prior to expiration? The forward market does not have a provision of cancelling the contract.
Instead, a party can terminate its position by entering into an opposite forward contract that has the same expiration date as the original contract.
Let’s take our previous example where Party A will buy the T-bill from Party B at a price of $985 30 days from now.
Assume that 10 days have passed, and after 10 days a 20-day forward price of a 90-day T-bill is $988. At this time, the original contract effectively has a negative value of $3 for the short (Party B). Party B expects price to rise even more and wants to control its losses. He can terminate/exit this contract by entering into an opposite forward contract to buy the T-bill at a price of $988 with an expiry 20 days from now (same day as the original contract).
The short (Party B) now has two opposite obligations:
- To sell a T-bill for $985 after 20 days
- To buy a T-bill (identical) for $988 after 20 days
This way Part B has locked in its loss at $3 irrespective of how the market price moves.
Note that the new opposite contract can be with the same counterparty (Party A) or with another party altogether. If the second contract is with the same counterparty, there is no credit risk. Party B can make the net payment of $3 to Party A at the time of contract expiry. In such a case, the counterparty (Party A) may even allow for an early termination of the original contract, if Party B agrees to make an immediate payment.
However, if the new contract is with another counterparty, the credit risk still exists, because the counterparty in the second transaction may not fulfill its obligation.
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