222 CHAPTER 6. THE MARKET FOR CURRENCY FUTURES
price to determine the value of the outstanding contract. Rather, one has to compute
the bounds on the fair value (using the Law of the Worst Possible Combination),
and negotiate some price within these bounds. Thus, the early settlement of forward
contracts is rather inconvenient. As a result, and in contrast to futures contracts,
virtually all forward contracts remain outstanding until they expire, and actual
delivery and payment is the rule rather than the exception. Closing out, if done at
all, often is via adding a reverse contract, as we have seen. While this works out
well enough most of the time, a long and a short do not add up to a zero position
if there is default:
Example 6.3
Some time ago you boughtusd15m forward from the Herstatt & Franklin, your
favorite bank, but you have just closed out by selling to it, same amount and same
date. You think you’re out; however, if prior toT H&Fhave gone into receivership,
then you have a problem. One of the two contracts probably has a negative value
to you and the other a positive one. Then the bank’s receivers will make you pay
for the one with the negative value. For the contract with a positive value, though,
you can only file a claim with the receivers, andmaybeyou’ll see part of your money
some day.
6.1.3 Reducing Default Risk by Variable Collateral or Periodic Re-
contracting
As we saw in the previous section, one often needs to post margin when a forward
contract is bought or sold. The margin may consist of an interest-earning term
deposit, or of securities (like stock or bonds). Please note that posting margin is
very different from paying something to the bank. A payment is made to settle a
debt, or to become the owner of a commodity or a financial asset. Whatever the
reason for the payment, the bank that receives a payment becomes the owner of the
money. In contrast, margin that is posted still belongs to the customer; the bank
or broker merely has the right to seize the collateral if and only if the customer
defaults.
The required margin can be quite high because the bank is willing to take only
a small chance that the contract’s expiration value, if negative, is not covered by
the margin. In about half of the cases, the collateral will turn out to have been
unnecessary because there is roughly a 50 percent chance thatS ̃T−Ft 0 ,T will end
up being positive. There are two ways to reduce the need for margin.
- Variable collateralUnder this system, the bank requests two kinds of margin.
First, there is a small but permanent margin—say, the amount that almost surely
covers the worst possible one-day drop in the market value of the forward contract.
If the market value of the contract becomes negative, the bank then asks for
additional collateral in order to cover at least the drop in the current market value
of the forward contract. If the customer fails to put up the additional margin, the