Insurance master

To illustrate how credit risk affects a forward contract, consider the currency forward contract example we just finished in the previous posts. It concerns a contract that expires in 180 days in which the long will pay a forward rate of $0.6008 for each Swiss franc to be received at expiration. Assume that the contract covers 10 million Swiss francs. Let us look at the problem from the point of view of the holder of the long position and the credit risk faced by this party.
Assume it is the contract expiration day and the spot rate for Swiss francs is $0.62.
The long is due to receive 10 million Swiss francs and pay $0.6008 per Swiss franc, or $6,008,000 in total. Now suppose that perhaps because of bankruptcy or insolvency, the short cannot come up with the $6,200,000 that it would take to purchase the Swiss francs on the open market at the prevailing spot rate.27 In order to obtain the Swiss francs, the long would have to buy them in the open market. Doing so would incur an additional cost of $6,200,000 – $6,008,000 = $192,000, which can be viewed as the credit risk at the point of expiration when the spot rate is $0.62. Not surprisingly, this amount is also the market value of the contract at this point.
This risk is an immediate risk faced at expiration. Prior to expiration, the long faces a potential risk that the short will default. If the long wanted to gauge the potential exposure, he would calculate the current market value. In the example we used in which the long is now 40 days into the life of the contract, the market value to the long is $0.0499 per Swiss franc. Hence, the long’s exposure would be 10,000,000($0.0499) = $499,000. Although no payments are due at this point, $499,000 is the market value of the claim on the payment at expiration. Using an estimate of the probability that the short would default, the long can gauge the expected credit loss from the transaction by multiplying that probability by $499,000.
The market value of a forward contract reflects the current value of the claim at expiration, given existing market conditions. If the Swiss franc rises significantly, the market value will increase along with it, thereby exposing the long to the potential for even greater losses. Many participants in derivatives markets estimate this potential loss by running simulations that attempt to reflect the potential market value of the contract along with the probability of the counterparty defaulting.
We have viewed credit risk from the viewpoint of the long, but what about the short’s perspective? In the case in which we went to expiration and the short owed the long the greater amount, the short faces no credit risk. In the case prior to expiration in which the contract’s market value was positive, the value of the future claim was greater to the long than to the short. Hence, the short still did not face any credit risk.
The short would face credit risk, however, if circumstances were such that the value of the transaction were negative to the long, which would make the value to the short positive.