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Hi Mr, Moffat.
Want to confirm my understanding on forwards default risk and a tad bit confused on default risk on fra.
I’ll go ahead with forwards first.
We have to make the payment to the bank to satisfy the forward contract. In case we can’t come up with the payment. That’s the default risk. Am I correct?
Now moving on to fra.
I don’t know why it is saying counterparty risk. I mean how can the bank default?
And similarly we have to come up with interest payment on the rate fixed? Is that the default risk resting with us. Rather than bank what I wrote above.
The default risk is the risk that either of the parties to the deal might not fulfil their obligation.
Obviously there is the risk that the company using a forward rate or an FRA might not be able to pay the required amount. However there is also the risk that the other party might not be able to do what is required. Although OTC arrangement would most likely be with a bank, it does not have to be a bank (and even if it is with a bank then although banks are not so likely to collapse it certainly can (and has) happened 🙂 )
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