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Subject 5. Credit risk and forward contracts

Credit risk in a forward contract arises when the counterparty that owes the greater amount is unable to pay at expiration or declares bankruptcy prior to expiration.

The market value of a forward contract is a measure of the net amount one party owes the other. Only one party, the one owing the lesser amount, faces credit risk at any given time. Because the market value can change from positive to negative, however, the other party has the potential for facing credit risk at a later date.

Counterparties occasionally mark forward contracts to market, with one party paying the other the current market value; they then reprice the contract to the current market price or rate. Marking to market keeps one party from becoming too deeply indebted to the other without paying up.

Study notes from a previous year's CFA exam:

d. evaluate credit risk in a forward contract, and explain how market value is a measure of exposure to a party in a forward contract.