5.1. PRACTICAL ASPECTS OF FORWARDS IN REAL-WORLD MARKETS 173
Figure 5.2: The bid-ask spread in a forward is wider than in a spot(negative) (positive)[spot][swap]
[forward][spot]
[swap][forward]Key For negative swap rates the bid is the bigger one , in absolute terms, while for positive swap
rates the ask is the bigger one. This is equivalent to observing a larger total bid-asp spread in the
forward market.
second reason is that, over short periods, things generally do not change much,
but a lot can happen over long periods. Thus, a bank may be confident that the
customer will still be sound in 30 days, but feel far less certain about the customer’s
creditworthiness in five years. In addition, also the exchange rate can change far
more over five years than over 30 days; so the farther the maturity date, the larger
also the potential loss if and when default would happen and the bank would have to
close out,i.e.reverse, the forward contract it had signed with the customer att 0.^1
Thus, banks build in a default-risk premium into their spreads, which, therefore,
goes up with time to maturity. Later on we will see by how much the spreads can
go up maximally with time to maturity.
The Second Law keeps you from getting irretrievably lost when confronted with
bid-ask swap quotes, because the convention of quoting is by no means uniform
internationally. Sometimes the sign of the swap rate (+ versus –; or p versus d)
is entirely omitted, because the pros all know that sign already. Or sometimes the
swap rates are quoted, regardless of sign, as “small number–big number,” followed
by p (for premium) or d (for discount). When in doubt, just try which combination
generates the bigger spread.
Let us now address weightier matters: how is credit risk handled?5.1.2 Provisions for Default
Forward dealers happily quote forward rates based on interbank interest rates, even
if their counterpart is much more risky than a bank. Shouldn’t they build risk
spreads into the interest rates, like when they lend money? The answer is No (or, at
most, Hardly): while the bank’s risk under a forward contract is not entirely absent,
it is still far lower than under a loan contract. Banks have, in effect, come up with
various solutions that partially solve the problem of default risk:
(^1) Note that the exchange risk is only relevant if and when the customer defaults. Normally, a
bank closes its position soon after the initial deal is signed, but this close-out position unexpectedly
turns out to be an open one if and when the customer’s promised deal evaporates. In short, exchange
risk only arises as an interaction with default risk.