6.1. HANDLING DEFAULT RISK IN FORWARD MARKETS: OLD & NEW TRICKS 223
bank seizes all margin put up in the past—including the initial safety margin—
and closes out the outstanding contract in the forward market. Obviously, under
such a system the amount of collateral that has to be put up is far smaller, on
average, than what is required if a single, large initial margin has to be posted.
The reason is that, under this system, collateral is called for only when needed,
and only to the extent that it is needed at that time.- Periodic recontracting. Under this system, the new market value of yesterday’s
contract is computed every day. The party that ends up with a negative value
then buys back the contract from the counterparty, and both sign a new contract
at the day’s new price. If the loser fails to settle the value of yesterday’s contract,
the bank seizes the initial margin, and closes out the contract in the forward
market. Under this system, only a small amount of margin is needed, since the
collateral has to cover only a one-day change in the market value.
It is useful to spell out the cash flows, because this will help you understand what
futures contracts are and why they differ from recontracted forwards.
Example 6.4
Suppose that, at time 0, Smitha Steel has bought forwardusd againstinrfor
delivery at time 3. In Table 6.1 we describe the implications under the systems
of variable collateral and periodic contracting, respectively. We ignore the initial
margin, since it is the same in both cases. All amounts are ininr. The example
assumes that the forward rate always goes down, as this is the possibility that
Smitha’s bank worries about.
With variable collateral, nothing is changed relative to a standard contract (ex-
cept that collateral is asked only if and when needed): Smitha has temporarily
moved some assets from her own safe to a safe of her bank, but gets them back
upon payinginr40m at time 3, as promised under the forward contract. With
recontracting, in contrast, there are three genuine payments, one per day, but by
design their time-value-corrected final value is still equal toinr40m at time 3. To
see this, just consider the total paid, at time 3, when the interim losses are financed
by loans which are paid back at time 3:
- time 1: pay (40−38)/ 1. 02
︸ ︷︷ ︸
1.961 borrowed
× 1 .02 = 40−38 = 2
- time 2: pay (38−36)/ 1. 01
︸ ︷︷ ︸
1.98 borrowed
× 1 .01 = 38−36 = 2
- time 3: pay 36
- total: pay 40
So the discounting, which is part of the market value calculations that are behind
the recontracting payments, also means that after taking into account time value
the recontracting cancels out: it can be “undone” by financing any losses via loans,
or by depositing any gains, thus shifting all cashflows back to timeT= 3.