Counterparty Collateral and Documentation · Forwards Trading Guide

A forward can gain market value while becoming harder to collect. Counterparty risk concerns whether the other party can perform when that value is needed.

Measure replacement exposure

If a forward is worth $20,000 to your business and the counterparty defaults, replacing the favourable position can cost money. The full contract notional is not automatically the current credit loss. Exposure also depends on recoveries, collateral, enforceable netting and the cost of replacing the trade. Before settlement, replacement risk differs from the gross principal risk that can arise while currency payments are in transit.

Follow the business consequence

Assume an importer locked a currency purchase for $500,000. After a market move, an equivalent replacement would cost $530,000. If the original provider fails and no recovery is immediately available, the importer still owes its supplier and faces a $30,000 replacement disadvantage. The commercial invoice does not disappear with the hedge provider.

Look for linked deterioration

Wrong way risk occurs when exposure grows as the counterparty’s ability to pay weakens. For example, a commodity buyer’s finances and the value of a contract with that buyer may deteriorate together during a severe market shock. Do not treat a current credit rating or a small present exposure as a complete assessment of the future relationship.

Use several controls

Set counterparty limits, review financial strength, monitor concentration and understand collateral and termination terms. Diversifying providers can reduce one concentration while increasing operational complexity and reducing netting benefits. Legal enforceability and access to collateral require specific review. A commercially attractive price should not override uncertainty about who owes the payment and how it can be recovered.

Try it yourself

A portfolio has $80,000 of positive value and $50,000 of negative value with the same counterparty. Can the business always report only $30,000 of credit exposure?

Show the worked answer

No. That net figure depends on the applicable enforceable netting arrangement and other adjustments. Without the required legal basis, offsetting the two figures can understate exposure.

Further reading

Educational material. Numerical examples are hypothetical and exclude costs unless stated. Forward contracts create binding obligations and may require collateral or credit approval. Actual terms, access and risks depend on the agreement and jurisdiction.

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