How Forward Credit Exposure Changes as a Contract Moves In the Money
Summary
The document addresses why credit exposure on a forward may increase over its life even as uncertainty about the remaining market movement declines. The answer separates the likelihood of counterparty default from the potential loss if default occurs. At inception, a fairly priced forward generally has little current value, so a default may leave the surviving party able to replace the trade near comparable terms, assuming liquid markets.
As market prices move, however, the forward can become valuable to one party. If the counterparty then defaults, the in-the-money party may lose a substantial amount and may be unable to replace the hedge at its original strike. The answer notes that exposure and default likelihood can move differently: default probability over the remaining period may fall while the loss severity from default rises. It also mentions mark-to-market arrangements as a way to reduce exposure. The explanation is qualitative and does not quantify exposure profiles, default probabilities, collateral terms, or market liquidity.
Key ideas
- Credit exposure reflects both the chance of default and the loss if default occurs.
- A fairly priced forward generally starts near zero value, limiting immediate replacement exposure.
- An in-the-money forward can become costly to replace if its counterparty defaults.
- Mark-to-market arrangements can mitigate some forward counterparty exposure.
- Lower remaining default likelihood does not necessarily mean lower potential loss severity.
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Full text
# Why does the credit exposure of a forward increase with time # Why does the credit exposure of a forward increase with time According to Gregory, the most obvious driving force behind credit exposure is future uncertainty. He characterizes the credit exposure of a forward contract as increasing with time; where exposure is at its highest just before maturity. As maturity nears, wouldn't my future uncertainty drop, thus causing exposure to drop? EDIT Just thinking, if we're talking about positive exposure and ignoring negative exposure, might this have something to do with exposure increasing as we get more and more in the money as maturity nears ? ## Answer by rhaskett (score 3, accepted) https://quant.stackexchange.com/a/20752 Your edit gets at the heart of the matter. When you enter a forward contract it generally should be very close to net zero current value. So credit risk for either side is negligible and should the counterparty immediately default one can likely reenter the desired position with a second counterparty near the desired strike so future uncertainty not a large concern either at least if the market is liquid. However, as time progresses your contract may become significantly in the money. In this case the larger amount owed to you increases the counterparty risk at the same time it increases the chance the counterparty will default as they owe more money in general. Also, if the position has moved in your favor it is now very hard to take on a contract at a similar strike if the counterparty does default. This can be devastating if you were counting on these forwards as a hedge. So while the odds of a counterparty defaulting during the period of the contract decrease over time the pain from a default can increase significantly. Many forwards contracts will have some (usually banded) mark-to-market accounting to mitigate some of this risk.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.