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In: Finance

Why does forward contract have a higher counterparts risk than futures contract?

Why does forward contract have a higher counterparts risk than futures contract?

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Expert Solution

Futures contracts are traded organized exchanges while Forward contract are private contracts and typically do not trade.

Clearing house is the counterparty in all futures contracts while forward are contracts with the originating counterparty & have counterparty credit risk.  

The government usually regulates Futures market. The forward contracts are typically not regulated and are usually not traded on organized exchanges.

Forward carry both pre -settlement & settlement risk, since the counterparty may default on the obligation either prior to maturity or at maturity.

In a Futures contract the counterparties both long & short  have to post collateral in the form of initial margin in the margin account to the clearing house to protect it against default of either counterparty. The contracts are Mark to Market based on a daily basis based on the changes in the underlying asset's price. The clearing house may deposit or withdraw funds from the margin account based on the changes in price. Incase the margin posted falls below a threshold i.e. the maintenance margin, a margin call i.e. variation margin will be made to the party to deposit funds to the initial margin level.

This Mark to Market feature is typically not present in Forward contracts which makes them prone to counterparty risk.

  


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