Forward commitments subject to default are: A . forwards and futures. B . futures and interest rate swaps. C . interest rate swaps and forwards.
The correct answer and explanation is:
The correct answer is: C. interest rate swaps and forwards.
Explanation:
Forward commitments are financial contracts that obligate the parties involved to transact at a specified future date and price. These contracts can be subject to default risk, which is the risk that one party may fail to fulfill its obligations.
Let’s analyze the options:
- Forwards and futures:
Both are contracts to buy or sell an asset at a future date for a price agreed upon today. However, the key difference lies in their default risk:- Forwards are private agreements between two parties (over-the-counter, OTC). Because they are not standardized and not traded on an exchange, forwards carry a significant default risk. One party may default, and there is no clearinghouse to guarantee the contract.
- Futures are standardized contracts traded on exchanges, backed by a clearinghouse. This clearinghouse acts as an intermediary, reducing the default risk substantially. The clearinghouse requires margin deposits and marks to market daily, so futures have very low default risk compared to forwards.
- Futures and interest rate swaps:
As explained, futures have very low default risk due to the clearinghouse mechanism. Interest rate swaps, on the other hand, are OTC derivatives and are subject to default risk since they depend on the creditworthiness of the counterparty. - Interest rate swaps and forwards:
Both are OTC contracts and are subject to counterparty risk or default risk. Neither has a clearinghouse guarantee. Therefore, parties involved in these contracts face the risk that the counterparty might not meet its obligations at maturity.
Why are interest rate swaps and forwards subject to default risk?
- Forwards: They are tailor-made contracts without a centralized clearing system. This lack of standardization and absence of a third-party guarantee exposes both sides to the risk of non-performance.
- Interest rate swaps: These involve exchanging interest payments between parties based on a principal amount. Since swaps are OTC and depend on the counterparties’ financial stability, default risk is inherent.
Summary:
- Forwards and interest rate swaps are both forward commitments subject to default risk because they are privately negotiated OTC contracts without a clearinghouse to mitigate credit risk.
- Futures contracts are standardized and cleared through exchanges, significantly reducing default risk.
Thus, the correct answer is C. interest rate swaps and forwards.