174 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
- The right of offsetFirst and foremost, a forward contract has an unwritten
but time-hallowed clause saying that if one party defaults, then the other party
cannot be forced to do its own part of the deal; moreover, if that other party still
sustains losses, the defaulting party remains liable for these losses. Thus, if the
customer defaults, the bank that soldfcforward can now dispose of this amount
in the spot market (rather than delivering it to the defaulting customer) and keep
the revenue. There still is a potential loss if and to the extent that this revenue
(ST) would be below the amount promised (Ft 0 ,T), but even if nothing of this
can be recouped in the bankruptcy court the maximum loss is (Ft 0 ,T−ST), not
Ft 0 ,T.^2
Example 5.2
Citibank has sold forwardjpy100m atusd/jpy0.0115 to Fab4 Inc, a rock band,
to cover the expenses of their upcoming tour; but on the due date Citi discovers
they have declared bankruptcy. Being a careful banker, City had bought forward
the Yens it owed Fab4. Given the bankruptcy, Citi has no choice but to sell these
jpy100m spot at, say,ST =0.0109. The default has cost Citi 100m×(0.0115-
0.0109) =usd60,000. In contrast, if Fab4 had promisedjpy100m in repayment
of a loan, Citi might have lost the full 100m×0.0115 =usd1.15m. Since, under
the forward contract, Citi can revoke its own obligation the net loss is always
smaller, and could even turn into a gain.- Interbank: credit agreementsIn the interbank market, the players deal only
with banks and corporations that are well-known to one another and have signed
credit agreements for (spot and) forward trading—that is, agreements that they
will freely buy and sell to each other. Even there, credit limits are set per bank
to limit default risk. - Firms: credit agreements or securityLikewise, corporations can buy or sell
forward if they are well-known customers with a credit agreement providing—
within limits—for spot and forward trades, probably alongside other things like
overdraft facilities and envelopes for discounting of bills or for letters of credit.
The alternative is to ask for margin. For unknown or risky customers, the margin
may be as high as 100 percent.
Example 5.3
Expecting a depreciation of the pound sterling, Burton Freedman wants to sell
forwardgbp1m for six months. The 180-day forward rate isusd/gbp1.5. The
bank, worried about the contingency that the pound may actually go up, asks for
25 percent margin. This means that Mr. Freedman has to deposit 1m xusd/gbp
(^2) To obtain a security with the same credit risk in the case of a synthetic forward contract, the
bank would have to insist that the customer hold the deposit part of its synthetic contract in an
escrow account, to be released only after the customer’s loan is paid back. The forward contract is
definitely the simpler way to achieve this security—which is one reason why an outright contract
is more attractive than its synthetic version.