Forward Contracts – Settlement/Default Risk (T-bill Example)

We learned that a forward contract is a contract between two parties to buy/sell an underlying asset at a specified price on a specified date.

In this contract, the party that agrees to buy the underlying asset has a long forward position and the party that agrees to sell the underlying asset has a short forward position.

Since these are non-standardized contracts traded over-the-counter, there is also settlement/delivery risk and default risk.

Let's take the example of a forward contract with a T-bill as the underlying asset to illustrate how a forward contract works.

Assume a 180-day T-bill selling at 4%. This means that a $1,000 par T-bill is selling at $1,000 - $1000*0.04*(180/360) = $980. If this T-bill is held till maturity, it will fetch $1,000 to the investor.

Two parties can enter into a forward agreement such that Party A will buy this T-bill from Party B at a price of $985 30 days from now. This will be a forward contract.

Note that Party A is long the forward contract and Party B is short the forward contract. Both parties have fixed the price and time at which the T-bill will be delivered by Part B to Party A.

Irrespective of how the price moves after 30 days, the contract needs to be fulfilled by both parties, i.e., Party A will buy the T-bill from Party B at $985.

At the time of contract initiation, the contract has zero value, however, after the beginning of the contract, as the T-bill price changes, the contract will have some value, i.e., only one party will owe some money to the other. The contract will have negative value for the person who owes money, and it will have positive value for the person who is expected to receive money. Assume that the T-bill has a price of $990 on settlement date. The contract has a positive value of Part A and negative value for Party B.

Unlike a futures contract, a forward contract also doesn’t involve any cash flow (such as margin) at the initiation of the contract.

Due to this, there is a risk of default for both counterparties because there is a possibility that one of the parties will not fulfill its obligation. In the above case, where the T-bill price is $990 on settlement date, compared to the forward price of $985, there is a possibility of Party B defaulting on its obligation.